(upbeat music)
-: A chocolate manufacturer needed more accurate costs
to make sure their pricing was appropriate
and to identify weaknesses in their product range
and identify opportunities
for improving efficiency and profitability.
They asked us to undertake an activity-based
costing exercise to assist them with the allocation
of nearly $4 million of overhead.
Here we consider the application of ABC to a subset
of just four product lines.
Step one was to identify the main activities linked
to these products, which were determined by watching
the business in action and talking to employees
about what they do.
Activity incurs costs and having a list of activities
helps us allocate costs to product lines
based on cause-effect relationships.
From this analysis, we identified four key activities
that affect the indirect manufacturing costs
in different ways depending on the different products.
Step two involves creates cost pools by allocating
the total overhead of just under $4 million
to the four activity areas we identified in step one.
This allocation was based on how
and where the indirect manufacturing costs were incurred.
For example, warehouse lease costs
and storage refrigeration costs
were allocated to the storage and warehousing cost pool.
In step three, we need to establish what causes
the activity costs within the cost pools to be incurred.
These cost drivers are the events that happen
that drive or cause costs, and will help us allocate
the costs accurately to particular product lines.
For purchasing an inbound logistics,
every time a purchase order
or delivery of raw materials happens,
it will take time and effort to process
and move the materials around.
So the more orders that are placed and the more deliveries
that arrive, the greater the level of cost.
These costs will be allocated based on which product lines
require the most orders and deliveries.
Storing materials and finished goods is expensive,
and so counting the days that materials or finished goods
are stored on pallets is a good way
of systematically measuring the cost.
The product lines that require the most storage
will end up being allocated more overhead
based on the storage consumed.
With production and packaging,
the number of operating hours is the cost driver.
Because as the number of hours the production process runs
or increases, so too do indirect costs such as power
and water cleaning, and machinery, repairs and maintenance.
Sales and outbound logistics costs are also incurred
in a similar way to purchasing an inbound logistics.
The number of sales orders transactions
and outbound deliveries are cost drivers here.
Once we know what is causing the costs,
we need to count how often these activities
or drivers occur.
This takes a long time, involves observation,
reviewing documents and talking with employees.
Once we have these numbers, we can work out
the cost per event or transaction.
First, we divide each activity cost pool
by the total number of cost driver transactions.
This gives us the transaction cost rate for each activity.
This cost rate is what we use to allocate indirect costs
to the specific product lines.
For step six, we need the number of cost driver transactions
that occur for each of our four product lines.
Using this information we allocate
the indirect costs of each product
based on the number of cost driver transactions.
As you can see, only $1.8 million dollars in overhead
has been allocated to these four product lines.
Note that the remaining $2.1 million in overhead
would be allocated to other product lines.
For step seven, we can divide
the allocated indirect product costs
by the number of units produced
to obtain the overhead allocation per unit.
But beware, you haven't finished yet,
this is only the indirect unit cost.
We also need to combine this with the direct costs
to calculate the total product cost.
To recap, the purpose of ABC
is to find out important cause effect relationships
so that we can allocate our indirect costs more accurately.
This will mean our total product cost will be more accurate
because costs have been allocated
based on how each product line consumes
particular activities, rather than just being spread out
across all products in a more random fashion.
Which can occur when using
traditional overhead cost allocation methods.
Better costing information
will lead to better decision making in many areas
including cost control, pricing and product mix choices.