Activity-Based and Life-Cycle Costing

A factory makes a standard gear in thousands and a custom gear in hundreds. Each month it sets up machines, inspects parts and orders material far more often for the custom gear. If overhead is shared by machine hours alone, the custom gear looks cheaper than it is.

Three kinds of driver. A transaction driver counts how many times an activity is done (orders, inspections, set-ups). A duration driver counts the time it takes (set-up hours, inspection hours). An intensity driver charges directly for the resources used each time, for example a special inspection that uses an expensive tester.

Don’t confuse a cost pool with a cost driver. The pool is the money: all the set-up costs added together. The driver is the cause you divide it by: the number of set-ups. The pool divided by the driver units gives the rate.

Where it breaks. ABC needs good data and takes effort to set up, and the choice of activities and drivers is a judgement. Facility-level costs, such as the factory building, have no real driver, and any rule for sharing them is arbitrary. A firm with one product gains little.

For exams. Know the six terms, the three kinds of driver, the features of ABC and the comparison with traditional costing.

Activities cause costs; products use activities.

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Why overhead has grown. In a firm of the past, labour was most of the cost, so labour hours were a fair base. In a modern plant, machines, planning, quality checks and design are a large part of cost, and they do not rise with labour hours. That is why ABC became useful as overhead became a bigger share of cost.

A decision. A bank branch charges every customer the same overhead per account. Which customers would ABC show to be costing more than they pay, and what could the bank do about it?

Hosur Gears makes 8,000 standard gears and 1,000 custom gears with ₹6,00,000 of overhead. Charged by labour hours, the custom gear carries ₹120 of overhead. What does it actually cost to make?

Four levels of activity (Cooper and Kaplan). Unit-level activities occur with every unit made (machining, testing each item). Batch-level activities occur once per batch (ordering, set-ups, inspecting a lot). Product-level activities support a product line (design, drawings, product advertising). Facility-level activities support the whole plant (building upkeep, security, the plant manager’s salary). ABC matters most when batch and product-level costs are a big share of the total.

Traditional costing gives the custom gear ₹120 of overhead a unit, and ABC gives it ₹296. The standard gear is the other way round: ₹60 against ₹38. If the custom gear sells for ₹300 and has ₹100 of direct cost, traditional costing shows a profit of ₹80 a unit and ABC shows a loss of ₹96. The standard gear has been paying for part of the custom gear’s complexity.

Don’t think ABC creates cost. The total overhead, ₹6,00,000, is the same under both methods: ₹4,80,000 + ₹1,20,000 against ₹3,04,000 + ₹2,96,000. ABC only shares it differently, by cause. Only the split between products changes.

Where it breaks. The result depends on the pools and drivers chosen. Too few pools return to the traditional answer, and too many cost more to run than they are worth. Unit-level and facility-level costs are still shared on volume. A price rise alone may not be the right response to a loss on a product; redesign or fewer set-ups may be better.

For exams. Show the pools, the driver rates, the charge to each product and the comparison with the traditional method.

Pool the cost, find the driver, charge by use.

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What management can do. The ABC figures point to actions: cut the number of set-ups by making longer runs, simplify the custom gear, or price it to cover its true cost. Many firms use ABC for pricing, product-mix and cost-reduction choices rather than for the formal accounts.

A decision. Hosur’s customers for the custom gear say they will leave if the price rises to ₹420. Using ABC, what would you propose to keep them and stay profitable?

A hospital can buy a scanner for ₹70 lakh or for ₹1 crore. The cheaper one costs more to run and repair. Which is better? The purchase price is only one part of what an asset costs over its whole life.

Stages of a product’s life. Market research, specification, design, prototype, development, tooling, manufacture, selling, distribution, product support, and decommissioning. Much of the cost is fixed in design, long before production begins.

Characteristics. It traces costs and revenues over several periods. It compares design and development costs with the revenue of the product. Each phase brings its own threats and opportunities. The life of a product can sometimes be extended by finding new users or new uses.

Choosing a machine. Machine X costs ₹10,00,000 and runs and is maintained for ₹1,50,000 a year. Machine Y costs ₹7,00,000 and costs ₹2,50,000 a year to run. Each lasts 5 years and then sells for ₹1,00,000 (X) or ₹50,000 (Y). The firm discounts at 10%, with running costs at each year-end.

Machine Y is ₹3,00,000 cheaper to buy, but over its life it costs about ₹1,10,125 more in present-value terms. The discounted figures use an annuity factor of 3.7908 for the running costs and 0.6209 for the sale in year 5.

Don’t decide on purchase price alone. Using the price alone overstates the return on the cheaper asset and understates the budget needed to run it. A budget that leaves out future running costs makes profit look larger than it will be.

Where it breaks. Future costs, lives and sale values are estimates, and the answer can flip if the discount rate or life changes. Benefits are not always the same for each choice, so cost alone may not be the test. Costs such as downtime or disposal rules are easy to overlook.

For exams. Know the two types, the stages of a product’s life, the heads of whole-life cost, and the three purposes: choose between assets, judge benefits and build accurate budgets.

Count the cost of owning, not just the cost of buying.

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Design decides cost. The largest part of a product’s lifetime cost is usually committed at the design stage, even though most of it is spent later. That is why life-cycle costing pushes cost thinking back into design and specification, where changes are cheap.

A decision. A municipality can buy a ₹20 lakh diesel bus or a ₹30 lakh electric bus. List the life-cycle cost heads you would estimate for each, and say which estimate you trust least.