The following advice is offered to businesses that wish to provide coffee as part of their customer service.

Transcription

1 Chapter 4 Overhead costs Rea word case 4.1 The foowing advice is offered to businesses that wish to provide coffee as part of their customer service. The cost of a cup of coffee consists of more than the ingredients and the coffee machine. In order to get a fuy integrated picture of the cup costs, one needs to add costs for brewing time, ceaning time, waste of coffee, service and maintenance costs, machine depreciation, machine financing costs, fiter papers and other cost eements which might be invisibe to the eye. Even, unfortunatey, theft is a cost to incude. A these hidden costs have to be taken into account! Coffee shoud not ony be viewed as an additiona cost but rather as a way of improving business resuts and customer satisfaction. Therefore, rather than comparing coffee suppiers and systems just on costs, view them from the standpoint of: how can I achieve the best business resut with this? For tips, pease ook at our recipes and saes tips sections. The coffee systems made by Douwe Egberts wi offer a fuy transparent insight into the costs of your coffee service and wi be a great hep to you in making more money on your coffee saes! Source: accessed Sept Discussion points 1 What are the direct costs of a cup of coffee? 2 What are the indirect costs of a cup of coffee?

2 Chapter 4 Overhead costs 71 Contents 4.1 Introduction Production overheads: traditiona approach Aocating and apportioning indirect costs to cost centres Apportioning service department costs over production cost centres Absorbing overhead costs into products Overhead cost recovery Iustration Predetermined overhead cost rates Under-recovery and over-recovery of overheads More questions about overhead cost rates Activity-based costing (ABC) for production overheads Reasons for the deveopment of ABC Nature of an activity Roe of the management accountant Case study: Gen Lyon Hote Comparing traditiona approach and ABC Contrasting treatments Benefits caimed for activity-based costing What the researchers have found Range of methods of overhead absorption Research into ABC Using an ABC framework Summary 97 Learning outcomes After reading this chapter you shoud be abe to: State the main components of tota product cost. Expain the traditiona approach to aocating and apportioning production overheads to products. Expain how cost drivers may be used to aocate overhead costs in activitybased costing. Compare and contrast the traditiona and activity-based methods of deaing with overhead costs. Describe and discuss exampes of research into methods of overhead costing.

3 72 Part 1 Defining, reporting and managing costs 4.1 Introduction This chapter begins by outining traditiona procedures for recording the costs of production overheads and indicates some of the probems that are encountered. Many of these procedures remain a cornerstone of present-day management accounting, but some management accountants have ooked for new procedures. In particuar, activitybased costing (ABC) has been deveoped as a new way of recording overhead costs. A statement of the cost of a unit of output is shown in Tabe 4.1. It incudes the costs of materias and abour, which have been expained and discussed in Chapter 3. This chapter expains how overhead costs are recorded and traced to the output of the organisation. Figure 4.1 summarises the way in which costs are traced to products. It reates to a cost centre where the output consists of three different products (goods or services). The direct costs in Figure 4.1 consist of direct materias, direct abour and any other costs that are directy identifiabe with a product. We know how much materia is Tabe 4.1 Statement of cost of a production item Direct materias Direct abour Other direct costs Prime cost Indirect materias Indirect abour Other indirect costs Production overhead Tota product cost xxx xxx xxx xxx xxx xxx xxx xxx xxx Figure 4.1 Tracing costs of Products A, B and C in a singe cost centre

4 Chapter 4 Overhead costs 73 needed for the product, we know how much abour time is worked on the product and we know about any other costs reated ony to that product. So the arrows fowing downwards in Figure 4.1 show the direct costs of each product fowing directy to that product. Some materias, some abour and some other costs are cassified as indirect costs because they are spread across a range of products. These have to be shared in some way across the products. Figure 4.1 shows the overhead costs being apportioned ( shared ) across products. One debate in management accounting focuses on how to carry out that process of apportionment. This chapter presents two approaches in that debate. Section 4.2 brings together a the indirect costs of production and groups them under the heading production overhead cost. It describes the process of ensuring that overhead costs reach the products, using the traditiona approach. Section 4.3 sets out an aternative to section 4.2 by sharing out the production overhead costs using an activitybased costing approach. Section 4.4 compares the traditiona and the ABC approaches. Activity 4.1 Think about a journey you have made on pubic transport. What are the abour costs of operating one journey? What overhead costs are incurred by the organisation providing the transport? How might you find out whether the fares charged to passengers refect the cost of the transport service? Rea word case 4.2 The foowing extract is taken from a website on which the UK government expains how actvitybased costing can hep estimate the costs of providing a poice service. Activity-based costing (ABC) is a widey used costing system that seeks to pace an accurate cost on what an organisation produces. In poicing, the ABC mode has been deveoped to cacuate the costs of poicing activities thus enabing managers to continuousy improve poicing services. ABC is essentiay a oca management too that focuses on the Basic Command Unit (BCU) and ooks at the tota cost of poicing a given geographica area. It incudes a poicing services deivered by BCU staff, as we as contributions from headquarters operationa or organisationa support units. This enabes comparisons to be made over time across poice forces and between BCUs, and provides managers with a suite of information on Best Vaue processes. The benefits of ABC are that it: enabes BCU Commanders to make better use of their resources; enabes Poice Authorities and forces to identify how resources are being used and to make efficiency improvements, where necessary; empowers poice forces to justify additiona resources by presenting their current resource usage accuratey and transparenty; increases accountabiity and identifies gaps between resource usage and priorities thus aowing better comparison between forces. Source: Discussion points 1 Why is it important to know the overhead costs of different types of poice activity? 2 What types of overhead might be found in different types of poice activity?

5 74 Part 1 Defining, reporting and managing costs 4.2 Production overheads: traditiona approach Production overheads were defined in Chapter 2 as comprising indirect materias, indirect abour and other indirect costs of production. Indirect materias and indirect abour are expained in Chapter 3. Other indirect costs wi incude any item which reates to production and which is not a materias cost or a abour cost. The type of indirect cost depends on the nature of the business and, in particuar, on whether it is a manufacturing business or a service business. Exampes are: (In a manufacturing business): repair of machinery; rent of factory buidings; safety procedures. (In a service business): cost of transport to jobs; repacement of toos; protective cothing. Whatever their nature, a the production overhead costs have to be absorbed ( soaked up ) into the products. Normay the management accountant has to devise a scheme of aocation and apportionment. There are some essentia features for any successfu scheme. It must be: fair to a parties invoved in the process of aocation and apportionment; representative of the benefit each party gains from the shared cost; reativey quick to appy so that provision of information is not deayed; understandabe by a concerned. This chapter wi use arithmeticay simpe modes for iustrative purposes, athough the mechanism for apportionment ( sharing ) does not have to be arithmeticay simpe provided a computer can be used. The process described here has three stages: 1 aocating and apportioning indirect costs to cost centres; 2 apportioning service department costs over production cost centres; 3 absorbing costs into products. Definitions Aocate means to assign a whoe item of cost, or of revenue, to a singe cost unit, centre, account or time period. Apportion means to spread costs over two or more cost units, centres, accounts or time periods. (It is referred to by some textbooks as indirect aocation.) Absorb means to attach overhead costs to products or services. Aocation, apportionment and absorption in job costing: Direct materias are aocated to products. Direct abour costs are aocated to products. Indirect materias costs and indirect abour costs are aocated and apportioned to cost centres. Tota indirect costs of service cost centres are apportioned over production cost centres. Tota overhead costs of production cost centres are absorbed into products. 1 Figure 4.2 provides a diagram to show the three stages in the fow of indirect costs. The cacuations are expained in detai in section Aocating and apportioning indirect costs to cost centres There are two main types of cost centre in any business, namey service cost centres and production cost centres. The production cost centres are those directy invoved

6 Chapter 4 Overhead costs 75 Figure 4.2 Traditiona approach to the fow of indirect costs in the production activity, with the output being either goods or services to customers. The service cost centres are not directy invoved in the production activity but provide essentia backup to the production activity. To sustain ong-term profitabiity, the products of the business must se at a price which makes a profit after covering the costs of both the service and the production cost centres. The management accountant wi first of a divide the overhead costs into two categories: those which may be aocated as a whoe to each cost centre, and those which have to be apportioned (or shared) over a number of cost centres according to how the cost centres benefit from the cost incurred. Tabe 4.2 sets out some common methods of apportionment where costs are regarded as indirect so far as each cost centre is concerned. If the records were sufficienty detaied, then most of the costs in Tabe 4.2 coud be turned into items of cost which coud be aocated as a whoe to each cost centre, avoiding the need for apportionment. For exampe: eectricity meters coud be instaed in each cost centre to measure directy the cost of heating and ighting; empoyees coud be given tickets for the canteen which coud be coected and recorded for each cost centre; the production supervisor coud keep a diary of time spent in each cost centre; depreciation coud be cacuated for each machine; the insurance company coud be asked to quote a separate premium for each machine. However, a these procedures woud in themseves create a new cost of administration which the business might decide was too high a price to pay for a margina improvement in the accuracy of aocation of costs.

7 76 Part 1 Defining, reporting and managing costs Tabe 4.2 Exampes of methods of apportionment of costs over cost centres Cost item Rent of buiding Lighting Power for machines Production supervisor s saary Canteen costs Depreciation and insurance of machinery Method of apportionment over cost centres Foor area of each cost centre Foor area of each cost centre Number of machines in each cost centre Number of empoyees in each cost centre Number of empoyees in each cost centre Vaue of machinery in each cost centre Apportioning service department costs over production cost centres As expained earier, service cost centres exist to support production but do not make a direct contribution to the product. Once the costs of the organisation have been channeed into the various cost centres, they must be apportioned from service cost centres over production cost centres. The essentia features remain the same, namey that the method chosen must be: fair to a parties invoved in the process of apportionment; representative of the benefit each party gains from the shared cost; reativey quick to appy so that provision of information is not deayed; understandabe by a concerned. Tabe 4.3 sets out the tites of some service cost centres and gives exampes of some methods by which their costs coud be apportioned over production cost centres. Tabe 4.3 Exampes of methods of apportioning tota costs of service cost centres across production cost centres Service cost centre Maintenance department Empoyees restaurant and coffee bar Stores department Finished goods quaity inspection Safety inspectors Method of apportionment over production cost centres Number of machines in each cost centre Number of empoyees in each cost centre Tota vaue of stores requisitions from each cost centre Vaue of goods produced by each cost centre Number of empoyees in each cost centre Where service departments provide services to each other as we as to the production departments, various methods are possibe. The step method takes the service department with the argest overhead cost first and apportions it across a departments. The service department with the next argest overhead is then apportioned across a departments other than the one aready deat with. The repeated distribution method invoves continuous reapportionment of service department costs across cost centres unti the amount remaining in any service department is so sma that it can be ignored. An agebraic method invoves the use of simutaneous equations.

8 Chapter 4 Overhead costs 77 In many cases these give simiar answers. The step method, which is the simpest, is iustrated in the foowing exampe. Step method: exampe The hospita manager estimates that the services of the wages department and the services of the computer department shoud be apportioned on the basis of the number of empoyees in each department. Information is shown in Tabe 4.4. Tabe 4.4 Data for step apportionment of service department costs Surgica Medica Wages Computing Tota Staff numbers Overheads 50,000 40,000 9,000 30, ,000 The information in Tabe 4.4 ooks probematic because the computing department provides a service to the wages department and the wages department provides a service to the computing department. A process for apportioning costs from one to the other coud continue indefinitey in the absence of a rue to simpify matters. The step apportionment method provides this simpification by taking each department, one step at a time, and apportioning the costs of that department across the remaining departments. The method is shown in Tabe 4.5. Step 1. The department with the highest cost, Computing, is apportioned first in the ratio 8:4:3 across the two production cost centres and the remaining service cost centre. Step 2. The tota overhead cost of the second service department, wages, is then apportioned across the two production departments, surgica and medica, but no cost is apportioned back to computing. Step 3. Check the totas of the overhead costs in the two production departments are the same as the totas of the costs at the start of the process. Tabe 4.5 Step apportionment of service cost centres Production cost centres Service cost centres Surgica Medica Wages Computing Tota Staff numbers Overheads 50,000 40,000 9,000 30, ,000 Apportion 16,000 8,000 6,000 (30,000) computing 8:4:3 Sub-tota 66,000 48,000 15, ,000 Apportion 10,000 5,000 (15,000) wages 8:4 Tota 76,000 53, ,000

9 78 Part 1 Defining, reporting and managing costs Repeated distribution method Appying the repeated distribution method requires the costs of computing to be apportioned across surgica, medica and wages. Then the costs of wages are apportioned across surgica, medica and computing. This is repeated unti the cost remaining in the service department cost centres is very ow. For this exampe it requires seven apportionment cacuations. The resut is: Surgica 75,878 and Medica 53,122. This is a more accurate answer than that of the step method but the error eve of the step method, as a percentage of the repeated distribution method, is 0.1 per cent for Surgica and 0.2 per cent for Medica. That seems sufficienty ow to justify using the step method for practica purposes Absorbing overhead costs into products You have now reached the fina stage of the process where a the overhead costs are coected in the production cost centres, ready to be absorbed into products. The essentia features, as before, are that the method must be: fair to a parties invoved in the process of absorption; representative of the benefit each party gains from the shared cost; reativey quick to appy so that provision of information is not deayed; understandabe by a concerned. To absorb a fair share of overhead into each product, the method must make use of the best measure of work done on a product. The best measure is usuay abour hours or machine hours, depending on whether the production process is abour intensive or machine intensive. Direct abour hours are frequenty used because overhead cost is incurred when peope are working. The onger they work, the more overhead is incurred. The overhead cost is expressed as s of overhead cost per direct abour hour. However, sometimes direct abour hours are not the best measure of work performed. In a machinery-intensive environment, machine hours may be preferred to abour hours as a basis for absorbing overhead. The overhead cost is expressed as s of overhead cost per machine hour. There are occasions when the direct abour hours worked on a job are not known because they are not recorded. In such circumstances an overhead cost per of direct abour coud be appied but it has a disadvantage in that a change in the abour rate coud affect the amount of abour cost and hence the aocation of overhead. Where a products are identica, a cost per unit woud be sufficient. However, in a job-costing system such identica products are unikey. In summary, four possibe methods of absorbing overhead costs into products are: cost per direct abour hour cost per machine hour cost per of abour cost cost per unit Overhead cost recovery The overhead costs are absorbed into products so that a costs may be recovered by charging a seing price that covers costs and makes a profit. The process of absorbing overhead costs into products is aso described as overhead cost recovery. This is another exampe of the use of different words to describe the same idea in management accounting. You wi find that both descriptions are used.

10 Chapter 4 Overhead costs 79 Definition Overhead cost recovery means absorbing overhead costs into a unit of product so that the overhead costs wi eventuay be recovered in the sae of the product Iustration This section provides an iustration of the aocation and apportionment of overhead costs and shows how the overhead cost is absorbed into products. Kitchen Units Company assembes and finishes kitchen units to customers orders. Assemby invoves creating the basic units, whie finishing invoves adding the aminated surfaces and interior fittings as specified by the customer. The machinery and toos required for the work are kept in working order by a maintenance department. The assemby and finishing departments are production departments because they both do work on the product. The maintenance department is a service department because it heps the work of the production departments but does not dea directy with the product. The iustration in Exhibit 4.1 foows the sequence of Figure 4.2. It shows how the overhead costs of one month are aocated and apportioned, and then absorbs the costs to Product S, a kitchen unit which spends two hours in assemby and three hours in finishing. Tabe 1 in Exhibit 4.1 sets out the indirect costs incurred by the business. These costs reate to some or a of the three departments and must be shared among them on a fair basis. Tabe 2 sets out information about each department which wi be hepfu in this fair sharing. Tabe 3 apportions overhead costs across the three deparments. Tabe 4 apportions the costs of the service department to the two manufacturing departments. Tabe 5 absorbs overhead costs into a job. Exhibit 4.1 Iustration of the cacuation of an overhead cost rate Tabe 1 sets out the indirect costs incurred by the business on behaf of a departments taken together. The costs must be apportioned (shared) over the departments because there is insufficient information to permit aocation of costs as a whoe. Tabe 2 sets out reevant information about each department which wi be used in the process of determining an overhead cost rate. Tabe 1 Indirect costs incurred by the business Cost item Tota cost this month Indirect materias 36,000 Indirect abour 40,000 Rent 1,000 Insurance 1,600 Depreciation 2,000 Tota 80,600

11 80 Part 1 Defining, reporting and managing costs Exhibit 4.1 continued Tabe 2 Information about each department Assemby Finishing Maintenance Direct materias used for 400, ,000 not appicabe production Number of empoyees Foor area 100 sq m 200 sq m 100 sq m Vaue of machinery 30,000 50,000 20,000 Number of direct abour hours 55,000 64,000 not appicabe worked on production There are four steps in cacuating the overhead cost to be aocated to each job. Step 1: Apportioning costs over departments, using a suitabe method for each cost In Tabe 3, each of the cost items contained in Tabe 1 is shared across the three departments on an appropriate basis chosen from Tabe 2. Tabe 3 Apportioning (sharing) cost items over the three departments Tota Assemby Finishing Maintenance Indirect materias 1 36,000 16,000 20,000 ni Indirect abour 2 40,000 10,000 25,000 5,000 Rent 3 1, Insurance 4 1, Depreciation 5 2, , Tota 80,600 27,330 47,300 5,970 Notes: 1 The cost of indirect materias is ikey to be dependent on direct materias so the proportions appied in sharing out the indirect materias costs are 4:5. The direct materias are used ony in Assemby and Finishing, so the indirect materias wi reate ony to these two departments. 2 The cost of indirect abour is ikey to be dependent on the tota number of empoyees working in the organisation, so the proportions appied in sharing out the indirect abour costs are 10:25:5. 3 Rent costs may be shared out on the basis of foor space occupied by each department, in the proportions 1:2:1. 4,5 Insurance and depreciation may both be shared out by reference to the vaue of the machinery used in each department, in the proportions 3:5:2. Step 2: Apportioning service department costs to production departments on the basis of vaue of machines in each department The maintenance department provides service in proportion to the machinery used in each department, so it is appropriate to share out the maintenance costs on the basis of vaue of machinery in Assemby and in Finishing, in the proportions 30,000:50,000: 30,000 5,970 = 2,239 80,000 50,000 5,970 = 3,731 80,000

12 Chapter 4 Overhead costs 81 Exhibit 4.1 continued Tabe 4 Apportioning (sharing) maintenance costs between Assemby and Finishing Tota Assemby Finishing Maintenance Tota cost per department 80,600 27,330 47,300 5,970 (from Tabe 3) Transfer maintenance 2,239 3,731 (5,970) costs to Assemby and Finishing Tota per department 80,600 29,569 51,031 ni Step 3: Absorbing tota overhead costs of each production department into units produced during the period Dividing the tota cost of each department by the number of direct abour hours, we obtain the foowing overhead cost rates: Assemby: Finishing: 29,569/55,000 hours = pence per direct abour hour 51,031/64,000 hours = pence per direct abour hour Step 4: Finding the overhead costs of any job Now the overhead cost rate may be used to determine how much overhead cost shoud be charged to each job. The answer wi depend on the number of direct abour hours required in each production department, for any job. Take as an exampe job S, which spends 2 hours in the assemby department and 3 hours in the finishing department. The overhead cost aocated to job S is cacuated as foows: Tabe 5 Exampe of the aocation overhead cost to a job Department Cacuation Assemby pence 2 hours Finishing pence 3 hours Tota overhead cost 3.46 That s a there is to it. The process of aocation, apportionment and absorption of production overheads takes time because every cost has to be traced through to the product, but it is systematic in that a costs eventuay find their way through to a product. Activity 4.2 Return to the start of Exhibit 4.1 and try to work the exampe for yoursef. It is very important for ater chapters that you understand the purpose of Exhibit 4.1 and the method of cacuation used. There are some features of the tabes in Exhibit 4.1 which are worth noting for future reference. First, it is important to keep totas for each coumn of figures and a tota of a the coumn totas in order to ensure that there are no arithmetic errors that resut in costs appearing from nowhere or disappearing to obivion. Second, it is important to show working notes at a times because there are so many variations of possibe method that the person who reads your cacuations wi need the working notes to understand the method chosen.

13 82 Part 1 Defining, reporting and managing costs Predetermined overhead cost rates This chapter has expained methods by which actua overhead cost for a period may be absorbed into jobs. However, the cacuation of overhead cost rates based on the actua overhead costs incurred during the period means that job cost cacuations have to be postponed unti the end of the period, because the overhead cost cannot be obtained before that time. This creates practica probems where timey information on job costs is essentia if it is to be used for estimating the vaue of work-in-progress or cacuating monthy profit. As a resut of this demand for information before the actua costs are known, many businesses wi use predetermined overhead cost rates, estimated before the start of a reporting period. This rate wi then be appied to a output of the period. At the end of the period, when the actua overhead is known, there wi be an adjustment to bring the estimated overhead cost into ine with the actua overhead cost. Estimating the predetermined overhead rate How does a manager estimate the predetermined overhead cost rate? The estimate coud be based on the known overhead costs of previous periods. It coud be a best guess of what wi happen in the forecast period. The predetermined overhead cost rate is then appied to the output of the period. This is aso described as overhead cost recovery because the cost wi be recovered when the output is competed and sod. Estimates abound in accounting and part of the reporting process invoves expaining why the actua out-turn did, or did not, match up to the estimate. Provided the estimation process is carried out with care, the benefits of using predetermined overhead costs, in terms of having information eary rather than ate, by far outweigh the possibe negative aspects of having to expain differences between estimated and actua overhead costs charged to products. Chapter 15 introduces the techniques of standard costing and variance anaysis, which provide a forma means of anaysing and investigating differences between estimated and actua amounts. Tabe 4.6 gives the information necessary to cacuate a predetermined overhead cost rate. The steps of cacuation are then described. Tabe 4.6 Cacuating a predetermined fixed overhead cost rate Estimated direct abour hours for norma activity 10,000 hours Estimated fixed overhead cost in tota 50,000 Predetermined overhead cost rate 5 per direct abour hour Step 1. The accounting period is one month. Before the start of the month, the manager estimates that there wi be 10,000 abour hours worked, under norma activity conditions, and that fixed overhead of 50,000 wi be incurred. Step 2. The manager cacuates the predetermined fixed overhead cost rate as 5 per abour hour (= 50,000/10,000). Step 3. Throughout the reporting period, as work is done, the manager appies 5 of fixed overhead for every abour hour of each item of output from the business. If exacty 10,000 hours of work are carried out then each item of output wi carry its fair share of the overhead. The process of overhead cost recovery is compete Under-recovery and over-recovery of overheads The cacuations of overhead cost recovery are not aways as neat and tidy as in Tabe 4.6. This section expains how under-recovery and over-recovery can occur.

14 Under-recovered overhead: underestimating hours worked Chapter 4 Overhead costs 83 Supposing things do not work out as panned in Tabe 4.6. The manager finds out at the end of the month that ony 8,000 hours were actuay worked. In Step 3, a fixed overhead of 5 wi be charged to jobs for each hour worked, so 40,000 wi be charged in tota. We can aso say that there is recovery of 40,000. At the end of the month the manager confirms that the cash book shows the actua overhead cost incurred is 50,000, corresponding exacty to the estimated amount. The manager has a tota fixed overhead cost of 40,000 recovered (charged to jobs) but an actua cost of 50,000 as an expense for the financia profit and oss account. The fixed overhead cost recorded on the job records is said to be under-recovered. In the management accounting profit and oss account the fixed overhead eement of the cost of goods sod is recorded at 40,000 using the predetermined rate, and a separate cost of 10,000 is recorded as under-recovered fixed overhead, so that the tota fixed overhead expense of the month equas 50,000. Under-recovered overhead: underestimating overhead cost Suppose that the actua hours worked do match the expected hours, so that in Step 3 there is recovery of the fu amount of 50,000 (based on 10,000 hours at 5 per hour). However, when the manager checks the cash book, it shows that the actua overhead cost of the month is 55,000 due to an unforeseen rise in fixed service charges. The fixed overhead cost recorded on the job records is again said to be under-recovered. In the management accounting profit and oss account the fixed overhead eement of the cost of goods sod is recorded at 50,000 using the predetermined rate, and a separate cost of 5,000 is recorded as under-recovered fixed overhead, so that the tota fixed overhead expense of the month equas 55,000. Definition Under-recovered fixed overhead occurs when the overhead cost recovered (appied), using a predetermined overhead cost rate, is ess than the actua overhead cost of the period. This may be because the actua hours worked are ess than the estimate made in advance, or it may be because the actua overhead cost incurred is greater than the estimate of the overhead cost. Over-recovered overhead: underestimating hours worked Now suppose an aternative picture. The manager finds out at the end of the month that 11,000 hours were actuay worked. In Step 3, a fixed overhead of 5 wi be charged to jobs for each hour worked, so 55,000 wi be charged in tota. We can aso say that there is recovery of 55,000. At the end of the month the manager aso confirms that the cash book shows the actua overhead cost incurred is 50,000, corresponding exacty to the estimated amount. The manager has a tota fixed overhead cost of 55,000 recovered (charged to jobs) but an actua cost of 50,000 as an expense for the financia profit and oss account. The fixed overhead cost recorded on the job records is said to be over-recovered. In the management accounting profit and oss account the fixed overhead eement of the cost of goods sod is recorded at 55,000 using the predetermined rate, and a separate reduction in cost of 5,000 is recorded as over-recovered fixed overhead, so that the tota fixed overhead expense of the month equas 50,000. Over-recovered overhead: overestimating overhead cost Suppose that the actua hours worked do match the expected hours, so that in Step 3 there is recovery of the fu amount of 50,000 (based on 10,000 hours at 5 per hour). However, when the manager checks the cash book, it shows that the actua overhead cost of the month is 48,000 due to an unexpected rebate of charges for heating. The

15 84 Part 1 Defining, reporting and managing costs fixed overhead cost recorded on the job records is again said to be over-recovered. In the management accounting profit and oss account the fixed overhead eement of the cost of goods sod is recorded at 50,000 using the predetermined rate, and a separate reduction in cost of 2,000 is recorded as over-recovered fixed overhead, so that the tota fixed overhead expense of the month equas 48,000. Definition Over-recovered fixed overhead occurs when the overhead cost recovered (appied), using a predetermined overhead cost rate, is greater than the actua overhead cost of the period. This may be because the actua hours worked are greater than the estimate made in advance, or it may be because the actua overhead cost incurred is ess than the estimate of the overhead cost. Effect on profit If there is over-recovered fixed overhead then too much cost is charged in the management accounts, when compared to the actua cost incurred. The management accounting profit wi be too ow. To restore the profit to the actua eve achieved, the over-recovery must be deducted from the cost charged. If there is under-recovered fixed overhead, then too itte cost is charged in the management accounts, when compared to the actua cost incurred. The management accounting profit wi be too high. To restore the profit to the actua eve achieved, the under-recovery must be added to the cost charged More questions about overhead cost rates Overhead cost is one of those topics which make you want to ask a new question every time you have an answer to the previous question. Here are some of the questions which might have occurred to you in thinking about overhead cost rates: 1 Is it necessary to have an overhead cost rate for each cost centre or coud there be one rate to cover a production? 2 How is it possibe to cacuate an overhead cost rate per direct abour hour for fixed overhead costs when these do not vary with direct abour hours? 3 What is the best way of ensuring that the process of aocation, apportionment and absorption of costs most cosey represents the behaviour of those costs? The answers to a these questions wi be found in thinking about the four conditions for determining a suitabe overhead cost rate: fair to a parties invoved in the process; representative of the benefit each party gains from the shared cost; reativey quick to appy so that provision of information is not deayed; understandabe by a concerned. The answers are therefore as foows. Is it necessary to have an overhead cost rate for each cost centre or coud there be one rate to cover a production? If there is a wide product range and products spend different amounts of time in different cost centres, it woud be undesirabe to have one rate to cover a production because that singe rate woud average out the time spent in the different departments. Thus it is said that banket overhead cost rates or pant-wide rates shoud be avoided where possibe, or used with great caution. The overhead cost rate to use wi be one which can be used with confidence that it meets the four conditions stated earier. How is it possibe to cacuate an overhead cost rate per direct abour hour for fixed overhead costs when, by definition, fixed costs do not vary with direct abour hours?

16 Chapter 4 Overhead costs 85 This question is more difficut to answer and the best starting point is a reminder that accounting is often based on estimates. The fixed overhead costs wi have to be absorbed into products eventuay. However, this can ony be achieved accuratey after production is competed. Job cost estimation cannot aways wait that ong. Therefore, a predetermined fixed overhead cost rate is appied to each job on the basis of some measure of work done, such as direct abour hours. If the estimating process is accurate, the estimated hours to be worked wi equa the actua hours worked and there wi be no probem. If the actua hours are greater than, or ess than, the estimate, then there wi be a difference, referred to as over-appied or under-appied fixed overhead. (This subject is taken up again in Chapter 5.) What is the best way of ensuring that the process of absorbing costs into products most cosey represents the behaviour of those costs? This question has aroused considerabe excitement in management accounting circes in recent years, as some thinking peope reaised that too much time had been spent in reading textbooks and theorising. Researchers had omitted to find out whether the actua practice of management accounting was so bad after a. They therefore went out to ook and found that some practica management accountants were having some very good ideas, but that those ideas were not finding their way into textbooks. As a resut of those investigations, many artices and books have been written on the importance of cost drivers, which are the events that are significant determinants of the cost of an activity. If an oi company has an offshore patform where the supervisor is constanty caing up the heicopter for unpanned visits ashore, the tota transport cost for the oi company wi rise. The heicopter fight is the cost driver and the patform supervisor needs to be aware that the fight cost is part of the cost of running the patform. If a stores department is receiving frequent deiveries of sma quantities, the cost driver for the stores department is the number of deiveries. Cost drivers are not an earthshattering discovery in themseves, but they have been buit into a description of activitybased costing (ABC) which you wi find in section 4.3. Activity-based costing has ed many companies to re-examine their approach to aocating overhead costs to products, based on finding a method which most cosey modes the factors driving the cost. 4.3 Activity-based costing (ABC) for production overheads Activity-based costing (ABC) is a reativey new approach to aocating overhead costs to products. It focuses on the activities that drive costs (cause costs to occur). Definition Activity-based costing (ABC) traces overhead costs to products by focusing on the activities that drive costs (cause costs to occur). The proponents of the subject caim that ABC provides product cost information which is usefu for decision making. The caims of ABC wi be expored in this chapter by outining the principes and then examining a case study. There are five stages to estabishing an activity-based costing system. These are: 1 Identify the major activities which take pace in an organisation. 2 Identify the factors which most cosey infuence the cost of an activity. These factors are caed the cost drivers and are a direct indication of how the activity demands cost. 3 Create a cost poo for each activity and trace costs to cost poos. 4 Cacuate a cost driver rate as the tota costs in a cost poo divided by the number of times that the activity occurs. 5 Aocate costs to products using the demand for each activity.

17 86 Part 1 Defining, reporting and managing costs Figure 4.3 Activity-based approach to the fow of overhead costs Compare the ABC steps in Figure 4.3 with those of the traditiona approach in Figure Reasons for the deveopment of ABC 2 In the 1980s, Professors Cooper and Kapan in the USA found the focus on activities and cost drivers in some arge US manufacturing businesses which had become dissatisfied with the traditiona approach to overhead costing. Cooper and Kapan wrote up their observations as case studies at Harvard University and then pubished papers on their findings. The cause of change was that business organisations were changing their nature at the time, with an increase in indirect costs reated to changes in processes, new ways of deaing with customers, and new investment in more sophisticated operating systems. There was a swing from variabe to fixed overhead costs. Labour resources were repaced to some extent by automation. It became apparent that production voumes were no onger the main drivers of overhead costs. Organisations were ooking for a costing system that woud be more reaistic in tracking the consumption of resources that gives rise to cost Nature of an activity An activity, in its broadest sense, is something which happens in the business. An activity coud be using materias to make a physica product or using abour to carry out a service operation. In ABC anguage, that woud be an exampe of a unit activity, which is performed each time a product is produced. Other activities are performed to enabe output of products but are not so cosey dependent on how many units are produced. These are caed product-sustaining activities. Exampes woud be product design, product testing and marketing. Some activities are cassified as batch-reated activities which are fixed for a given batch of products. This woud incude costs of the buying department, costs of moving stores from the warehouse to the factory foor, and costs of panning a production schedue. Where there are expenses such as rent or

18 Chapter 4 Overhead costs 87 insurance which are not driven by making products, they are designated as faciitysustaining activities and no attempt is made to aocate these to products. They are charged as a tota cost against a products after the separate profit margins on each product are determined. Exampe 1 A anguage coege teaches Engish as a Foreign Language. It has two departments: E (European mother tongue) and A (Asian mother tongue). Information about each is shown in Tabe 4.7. The overhead cost of ceaning cassrooms is 32,000 per year. Tabe 4.7 Information for Exampe 1: departments E and A Department E A Number of teaching staff Annua teaching abour cost 600,000 1,000,000 Number of rooms The traditiona method of aocating ceaning overhead cost to departments has been to appy a rate of two per cent of the abour cost of teaching. This is shown in Tabe 4.8. Tabe 4.8 Traditiona treatment of ceaning overhead E A Overhead cost rate 2% of abour cost 2% of abour cost Apportionment of cost 32,000 12,000 20,000 The head tutor of Department A fees this is unfair because it has fewer cassrooms than Department E and so requires ess ceaning effort. Assume that ceaning cost may be regarded as a cost poo and show how activity-based costing can be appied where the number of cassrooms is the cost driver for ceaning. The apportionment of cost by the activity-based method is shown in Tabe 4.9. Tabe 4.9 Activity-based costing for ceaning overhead E A Cost poo: ceaning, 32,000 Cost driver: fraction of cassroom usage 18/34 16/34 Apportionment of cost 32,000 16,940 15,060 Comment. The head of Department A wi be happier with the use of activity-based costing because it refects the ower usage of ceaning driven by fewer cassrooms. On the other hand, it may be that this is not the best cost driver. For instance, suppose that the head of Department E responds by pointing out that their cassrooms are kept tidy and are therefore easier to cean. The debate over cost drivers might take some time to resove. Exampe 2 In the office of a firm of soicitors and estate agents there are overhead costs incurred reating to the cost of office support for the staff preparing ega documentation. There are two departments preparing ega documentation. Department A has deat with

19 88 Part 1 Defining, reporting and managing costs 15 property transactions having an average vaue of 100,000 each, whie Department B has deat with 5 property transactions having an average vaue of 1m each. The tota amount of the office overhead costs for the period is 100,000. The traditiona approach to overhead cost has been to apportion the amount of 100,000 in proportion to the number of property deas deat with by each department. They are now asking for an activity-based approach to costing, where the cost driver is the vaue of transactions in each department, because high vaue transactions invove more work. Tabe 4.10 Traditiona treatment of ceaning overhead A B Cost poo: office overhead, 100,000 Cost driver: number of transactions 15/20 5/20 Apportionment of cost 100,000 75,000 25,000 Cost per transaction 5,000 5,000 The traditiona approach gives the same unit cost regardess of size of transaction. Tabe 4.11 Activity-based costing for office overhead A B Overhead cost rate 1,500/6,500 5,000/6,500 Apportionment of cost 100, , / ,000 5/6.5 = 23,000 = 77,000 Cost per transaction 1,530 15,400 Comment. The activity-based approach puts much more of the overhead cost on to Department B because that one is driving more of the overheads. When the cost per transaction is cacuated, the activity-based approach, based on vaue, oads the cost towards the high-vaue transaction and so produces a reativey higher cost per unit for these transactions Roe of the management accountant Activity-based costing aows the attention-directing functions of the management accountant to come to the fore. The management accountant takes a key roe in understanding the operation of the business and transating into cost terms the activities as perceived by those who carry them out. Because activity-based costing requires a very thorough anaysis of how products drive the costs of various activities, it is not feasibe to work through a fu iustration here. Instead, one activity, that of purchasing materias for use in a hote restaurant, wi be expored by a case study in some detai. Hopefuy, that wi give you a favour of the compexity and fascination of ABC and encourage you to read further Case study: Gen Lyon Hote The Gen Lyon Hote has two main product ines, with quite different characteristics. In the restaurant, meas are provided on a daiy basis to the chef s high standards of perfection. In the conference suite, banquets are arranged for specia functions such as weddings. There is a restaurant manager, responsibe for restaurant meas, and a functions manager, responsibe for banquets. The hote seeks to offer competitive prices subject to meeting a costs and earning an adequate profit.

20 Chapter 4 Overhead costs 89 The hote has a purchasing department which purchases the food required by the hote restaurant and a suppies required for specia functions, incuding crockery and cutery. The purchasing officer is concerned that the restaurant manager insists on buying food in reativey sma quantities, because the chef is very particuar about monitoring the continued high quaity of suppies. The functions manager aso creates probems for the purchasing department because she insists on buying crockery and cutery in buk, to save cost, which requires time being taken by the purchasing officer to negotiate the best terms with the suppier. Even the suppiers can create a great dea of work because they are constanty changing their prices and this has to be recorded on the computer system of the purchasing department. The purchasing officer woud ike to show that these activities are a costy because they drive the amount of work undertaken by the purchasing department. Fiona McTaggart was caed in to hep, and she now expains how she went about the task of appying activity-based costing in reation to the activities of the purchasing department. FIONA: First of a I asked for a ist of a the costs incurred by the department in a year (see Tabe 4.12). Tabe 4.12 List of costs incurred by resources used in the purchasing department Resource cost Saary of purchasing officer 15,000 Wages of data processing cerk 9,000 Teephone cas 3,000 Tota costs to be aocated 27,000 Identifying the cost drivers Then I sat down with the purchasing officer for a ong meeting during which we taked about how the purchasing process worked. From those discussions I found that a number of activities were driving the work of purchasing and I isted a those (see Exhibit 4.2). Exhibit 4.2 List of activities in the purchasing department Agreeing terms with suppier Processing an order Updating the price ists Updating the suppier records Processing queries about invoices I expained to the purchasing officer that, athough the purchasing department was an identifiabe unit of the organisation for staff management purposes, it woud no onger be treated as a cost centre under activity-based costing. The purchasing process woud be regarded as a set of activities consuming resources such as saaries, wages and teephone cas. Each activity woud coect a poo of cost as the resources were used up. The poo of costs woud be passed on to those other departments drawing on the services of the purchasing department and from those departments the costs woud find their way into products. Creating the cost poos The next stage was to decide how much of each resource cost was attributabe to the activity driving that cost. This part was quite tricky because the purchasing officer ony had a fee for the reative impact in some cases. Take as an exampe the processing of an order. When the restaurant manager asks for food to be ordered, the purchasing officer

21 90 Part 1 Defining, reporting and managing costs first has to phone the suppier to check avaiabiity and ikey deivery time. Then she checks that someone wi be avaiabe to open the cod store when the deivery arrives. She is then abe to fax the order to the suppier who wi phone back to confirm that the goods are avaiabe and that deivery wi be as requested. Once the goods arrive, the purchasing officer has to check that the deivery note agrees with what was ordered. That whoe process takes about 20 minutes for each order. We carried on taking and I was abe to identify, for each resource cost, some measure of how the activity was being driven. The starting point was saaries. We estimated that the purchasing officer spent the equivaent of two days per week agreeing terms with suppiers. The remaining three days were divided equay over the other activities isted. For wages cost, the data processing cerk spent three days per week in processing orders, haf a day each week on updating price ists and updating suppiers records, and one day per week on checking and processing questions from the accounts department about invoices received for payment. The fina cost heading was teephone cas. The destination and duration of each ca is ogged by the teephone system so we took a sampe of one week s cas and decided that 60 per cent of teephone cas were routine cas to pace an order, 20 per cent were deaing with queries over price changes and the remainder were spread equay over agreeing terms, updating the suppier records and deaing with invoice queries. Foowing these discussions I sketched a diagram of the ABC approach (see Figure 4.4) and then drew up a tabe showing how each cost item coud be aocated to the various activities so that a cost poo is created for each activity (see Tabe 4.13). Figure 4.4 Sketch of the ABC approach appied to the activity of purchasing Tabe 4.13 Creating a cost poo: aocation of resource costs to activities Resource Resource cost Activity cost poos Agreeing Processing Updating Updating Processing terms with an order the price ist the suppier invoice suppier records queries Saary 15,000 6,000 2,250 2,250 2,250 2,250 Wages 9,000 5, ,800 Teephone 3, , ,000 6,200 9,450 3,750 3,350 4,250

22 Demand for each activity Chapter 4 Overhead costs 91 The next stage was to determine how many times each activity driver was put into action. This invoved measuring the voume of each activity, as a measure of the demand for that activity. Agreeing terms with the suppier is not easy to quantify, but we were aware that there are discussions with each suppier at some time during the year, so we took the number of suppiers as the measure of voume driving that activity. It was reativey easy to estabish the number of orders processed at the request of the restaurant manager. The price ist has to be updated every time the suppier changes the price of any items, and they a change at east twice per month, so we decided that the number of items on the order ist was a reasonabe measure. Updating suppier records invoves changing minor detais for existing suppiers but takes more time to record a new suppier. So we used the number of new suppiers as the measure of the voume of that activity. Processing invoice queries depends on the number of such queries. Cost driver rates My fina accounting statement was a cacuation of the cost per activity unit for each activity (see Tabe 4.14). This was determined by dividing the cost in the poo by the measure of how that activity was being driven by products. Tabe 4.14 Cacuation of cost per activity unit for each activity Activity cost poos Agreeing Processing Updating the Updating the Processing terms with an order price ist suppier invoice suppier records queries Cost per 6,200 9,450 3,750 3,350 4,250 Tabe 4.13 Activity driver Number of Number of Number of Number of Number of suppiers orders items isted suppiers queries updated Activity 60 1,600 7, voume Cost per activity unit Using the cacuation of cost per activity unit for each activity I was abe to expain the benefits of activity-based costing. The purchasing department is providing a service to the rest of the organisation, but at a cost. That cost coud be made more visibe using activitybased costing because the factors driving the cost coud be quantified in their effect. Looking at Tabe 4.14, it is not difficut to see that the most significant cost drivers are the activities of agreeing terms with suppiers and of updating the suppiers records. Each new suppier causes a further ( ) to be incurred at an eary stage. The restaurant manager needs to be aware that pacing arge numbers of owvoume orders causes cost to be incurred on each order. The tota cost incurred coud be reduced by moving to a ower number of orders, each being of higher voume. (Someone woud need to check that that did not create arger new costs in storage of the goods.) The next most costy activity, in terms of cost per unit, is that of answering queries about invoices. The accounts department shoud be made aware that each enquiry costs

23 92 Part 1 Defining, reporting and managing costs I aso ooked back to the od way of aocating the cost of the purchasing department (see Tabe 4.15). Before activity-based costing was considered, the organisation charged the purchasing costs to products as a percentage of the vaue of materias ordered. Looking back to Tabe 4.12, the tota purchasing department costs are shown as 27,000. The purchasing department handes goods to the vaue of 800,000 in a year. The purchasing department costs were therefore charged to products at per cent of cost. Tabe 4.15 Previous methods of aocation, based on percentage of vaue of items requested Restaurant Functions Accounts manager manager department Goods purchased through 300, ,000 purchasing department 3.375% of goods purchased 10,125 16,875 ni Why was this not the best approach? The answer is that there were two main product ines, having quite different characteristics. One was restaurant meas provided on a routine basis and the other was specia banquets for functions such as weddings. My further enquiries reveaed that the high-price purchases required for specia functions caused reativey few probems in agreeing terms with suppiers and reativey few queries arose over the invoices. Where probems of negotiation and invoicing did arise was in the ow-price, highvoume ingredients used routiney in the dining room meas. The information on cost per unit of each activity aowed a much more precise aocation of cost, athough I was now in for even more work in tracing the costs from the various activity poos through to the products. Tracing costs through to products To trace costs through to products I obtained estimates of the quantity of each activity demanded by the restaurant manager and the functions manager (see Tabe 4.16) and mutipied each quantity by the cost per activity unit cacuated in Tabe The resut is shown in Tabe Compare this with the cost aocation under the traditiona system which is shown in Tabe Tabe 4.16 Quantity of activity demanded by each function Activity Demanded by Demanded by restaurant manager functions manager Agreeing terms with suppier 10 new suppiers 50 new suppiers Processing an order 1,200 orders 400 orders Updating the price ist 4,000 items 3,000 items Updating the suppier records 10 new suppiers 50 new suppiers Processing invoice queries A 150 demanded by accounts department

24 Chapter 4 Overhead costs 93 Tabe 4.17 Aocation of purchasing cost to restaurant manager, functions manager and accounts department Activity Restaurant Functions Accounts Tota manager manager department Agreeing terms with suppier 1,033 5,167 6,200 Processing an order 7,088 2,362 9,450 Updating the price ist 2,143 1,607 3,750 Updating the suppier records 558 2,792 3,350 Processing invoice queries 4,250 4,250 Tota cost aocated 10,822 11,928 4,250 27,000 My concusions were that the accounts department had previousy been unaware of the costs it was causing the purchasing manager whenever an invoice query was raised. Using activity-based costing woud aow the aocation of cost to the accounts department each time a question was raised. Some care might need to be taken to examine the size and significance of the invoice query in reation to the cost aocation. It woud not be a good idea for the accounts department to aow a 50,000 error to go unchecked because they feared a charge of The impementation of activity-based costing might need to be accompanied by the use of performance measures which show how the benefits of an activity exceed the costs incurred. The functions manager woud incur ess overhead cost under the activity-based system than under the previous approach. The recorded cost of functions woud therefore decrease. As I expained earier, the high-priced purchases of food for specia functions cause reativey few probems in processing a smaer number of orders. The functions manager seems to have a reativey high number of new suppiers. Cost coud be controed further if fewer suppiers were used for functions. Less purchasing effort woud be required. The restaurant manager experiences itte difference in cost under either approach. To improve overhead costs there woud need to be a quantum eap in practice, such as reducing the order frequency to the stage where one ess person was empoyed in the purchasing department, or ese where a part-time empoyee coud do the work presenty undertaken fu-time. Merey reducing the order frequency woud not be enough if the purchasing staff are sti present fu-time and the same cost is being spread over a ower voume of activity. Athough there is itte impact, these figures give the restaurant manager food for thought. Product costs In the fu appication of ABC, the costs woud be taken into the fina product cost. I have not done that here because the purchasing department s costs are ony one sma corner of the tota business. Activity-based costing creates a ot of work, but a we-coded computerised accounting system can hande that. I spent the best part of one day deaing ony with the anaysis of the purchasing department costs, so it woud take a few weeks of consutancy to cover the entire range of activities which contribute to the cost of the products. My consutancy fees woud be another overhead to be aocated, but I beieve the hote woud find the effort we worth it in terms of more effective management over a period of years.

25 94 Part 1 Defining, reporting and managing costs Activity 4.3 Imagine you are the owner of a business which rents ice-cream stas from the oca counci. You empoy persons to run each sta. Write down a ist of the costs you woud expect to incur. Write another ist of the drivers of cost. How coud activity-based costing hep you understand and contro the costs of your business? 4.4 Comparing traditiona approach and ABC Contrasting treatments Aocating direct costs to products is not a probem. The particuar need for activitybased costing ies in the area of absorbing overhead costs into products. The traditiona approach to absorbing overhead costs to products was expained in section 4.2. In that section it was shown that, traditionay, costs are first aocated and apportioned to cost centres and then absorbed into products which pass through those cost centres. Activity-based costing foows a different approach to channeing costs towards products. Tabe 4.18 sets out the contrasting treatments. Tabe 4.18 Contrasting activity-based costing and traditiona overhead cost aocation Traditiona overhead cost aocation Identify cost centres in which costs may be accumuated. Cost centres are determined by the nature of their function (e.g. production or service department cost centres). Activity-based costing Identify the way in which products drive the activity of the business and define suitabe cost poos for coecting the costs reating to each activity. Activity cost poos are determined by the activities which drive the costs (e.g. obtaining new customers, negotiating customer contracts). Coect costs in cost centres. Coect costs in activity cost poos. Determine an overhead cost rate for each production cost centre (e.g. cost per direct abour hour). Determine a cost driver rate for each activity cost poo (e.g. a cost per customer contract, cost per customer order received). Aocate cost to products using the cacuated cost rate and the measure of the product s consumption of that department s cost (e.g. number of abour hours required). Aocate cost to products according to the product s demand for the activity which drives cost Benefits caimed for activity-based costing Activity-based costing (ABC) appeared first in the academic iterature during the ate 1980s. It had reached the professiona accountancy journas by the eary 1990s and by that time was aready being used (or tested) by companies with progressive attitudes.

26 Chapter 4 Overhead costs 95 It has not been appied in a cases, but the idea of asking what drives cost is found in many situations. The main benefits caimed are that ABC provides product cost information which, athough it incudes an aocation of overheads, is nevertheess usefu for decision-making purposes. It is usefu because the overhead costs are aocated to the products in a way that refects the factor driving the cost. If a product cost is thought to be too high, then it can be controed by controing the factors driving the most significant eements of its cost. Attention is directed towards probem areas. Activity-based costing is seen as a vauabe management too because it coects and reports on the significant activities of the business. It is aso attractive for service-based organisations which have found that the traditiona, manufacturing-based costing methods are not suited to the different nature of the service sector. Rea word case 4.3 The foowing extract continues the aw and order theme of Rea word case 4.2. It expains the use of activity based costing in the Crown Prosecution Service, where decisions are taken on whether a case shoud be taken to court for tria. The broad concept of activity costs within CPS is that the number of fies handed, mutipied by staff time, is equa to the tota cost of staff time spent on the CPS prosecution process. The system is buit purey on staff time and excudes accommodation and other anciary costs, e.g. Capita. ABC does not repace performance indicators but iuminates them to make their messages more meaningfu. Indicators on their own are rather ike the contros in a car which te you how many revs and what speed you are doing, but not if you are a good driver or are respecting the speed imit. After a, the simpe cost of a case can aways be determined by dividing expenditure by caseoad but this tes you nothing about the efficiency or quaity of the product or how the organisation is running, ony how much the case costs on average. Source: Discussion points 1 What is the benefit of ABC in the situation described here? 2 Do you agree with excuding costs such as accommodation and the cost of capita as expained in the artice? You may ask at this point, If activity-based costing is the best approach, why has it not repaced the traditiona approach to overhead cost apportionment? The answer to that question is, first, that the technique is sti reativey rare in practica appication, despite the amount written about it. Second, no aocating mechanism can produce accurate resuts uness the cost item which is being processed is of high reiabiity and its behaviour is we understood. The successfu appication of activity-based costing depends on a thorough understanding of basic principes of cost behaviour and the abiity to record and process costs accuratey.