Table 1 has been amended to include the fixed overheads to be absorbed in both products.
Ordinary: (5 labour hours x $2 OAR) = $10
Deluxe: (6 labour hours x $2 OAR) = $12
This means we have arrived at the total production cost for both products under absorption costing. It also tell us that if production goes according to budget then total costs will be (20,000 x $85) + (2,000 x $102) = $1,904,000.
The conventional approach outlined above is satisfactory if the following conditions apply:
- Fixed costs are relatively immaterial compared to material and labour costs. This is the case in manufacturing environments which do not rely on sophisticated and expensive facilities and machinery.
- Most fixed costs accrue with time.
- There are long production runs of identical products with little customisation.
However, much modern manufacturing relies on highly automated, expensive manufacturing plants – so much so that some companies do not separately identify the cost of labour because there is so little used. Instead, factory labour is simply regarded as a fixed overhead and added in to the fixed costs of running the factory, its machinery, and the sophisticated information technology system which coordinates production.
Additionally, many companies rely on customisation of products to differentiate themselves and to enable higher margins to be made. Dell, for example, a PC manufacturer, has a website which lets customers specify their own PC in terms of memory size, capacity, processor speed etc. That information is then fed into their automated production system and the specified computer is built, more or less automatically.
Instead of offering customers the ability to specify products, many companies offer an extensive range of products, hoping that one member of the range will match the requirements of a particular market segment. In Example 1, the company offers two products: Ordinary and Deluxe. The company knows that demand for the Deluxe range will be low, but hopes that the price premium it can charge will still allow it to make a good profit, even on a low volume item. However, the Deluxe product could consume resources which are not properly reflected by the time it takes to make those units.
These developments in manufacturing and marketing mean that the conventional way of treating fixed overheads might not be good enough. Companies need to know the causes of overheads, and need to realise that many of their ‘fixed costs’ might not be fixed at all. They need to try to assign costs to products or services on the basis of the resources they consume.
Activity-based costing
What we want to do is to get a more accurate estimate of what each unit costs to produce, and to do this we have to examine what activities are necessary to produce each unit, because activities usually have a cost attached. This is the basis of activity-based costing (ABC).
The old approach of simply pretending that fixed costs are incurred because of the passage of time, and that they can therefore be accounted for on the basis of labour (or machine) time spent on each unit, is no longer good enough. Diverse, flexible manufacturing demands a more accurate approach to costing.
The ABC process is as follows:
- Split fixed overheads into activities. These are called cost pools.
- For each cost pool identify what causes that cost. In ABC terminology, this is the ‘cost driver’, but it might be better to think of it as the ‘cost causer’.
- Calculate a cost per unit of cost driver (Cost pool/total number of cost driver).
- Allocate costs to the product based on how much the product uses of the cost driver.
Let’s continue with our example from earlier; the total fixed overheads were $224,000. In the table below in Example 2 the total overheads have been split into cost pools and cost driver data for the Ordinary and Deluxe products has been collated.
Example 2