Accounting Business Reporting for Decision Making

CHAPTER 11 Costing and pricing in an entity 469

driver (but not necessarily the underlying cost) will be burdened with a higher proportion of indirect

costs. This may lead to the entity making incorrect decisions. For example, if cross-subsidisation has

caused incorrect measures of product profitability, an entity might attempt to boost sales on the more

profitable product by allocating more of the advertising budget to promote sales. However, this could

lead to the promotion of a product that is less profitable due to the incorrect allocation of indirect

costs.

Resource drivers are factors that measure resource consumption by activities. Such drivers enable

costs to be assigned to activities. For example, the accounting system will have costs collected in

accounts for electricity, rent, rates, salaries and so on. In the case of electricity, costs may be allocated

to activities based on kilowatt hours and rent based on the metres of floor space where the activity

takes place. Activity drivers are then used to assign the costs from the activities to the cost object.

Activity drivers represent the attributes of the individual activities and recognise that factors other than

volume cause indirect costs to be used by cost objects. For example, rather than using machine hours

as the cost driver, further investigation of the processes might reveal that other factors cause the con-

sumption of indirect costs. Such factors could be the time taken to set up the machine, the number of

machine set-ups, the type of labour used, or the type of material or packaging used. Cross-subsidisation

is addressed by using activity drivers, as the indirect costs are allocated to the cost objects that make use

of that particular activity.

When developing a costing system based on activities, reference to an activity hierarchy can assist

in identifying the most appropriate type of cost driver. The activity hierarchy is a framework that

describes how indirect costs change with various activities. For a manufacturing entity, the hierarchy

would include:

• unit level costs — costs incurred for each unit of output (e.g. the cost of electricity to operate machines)


• batch level costs — costs incurred for the benefit of a group of products simultaneously (e.g. the cost

of setting up machines to manufacture batches of product)

• product level costs — costs incurred for the benefit of a specific product family (e.g. the cost of

designing specific products)

• facility level costs — costs incurred for the benefit of the entire entity (e.g. the cost of operating the

entity’s headquarters).

The activity hierarchy shows that a volume driver would be appropriate only for a unit level cost.

The specific levels in the hierarchy can be adapted to suit the characteristics of individual entities. For

example, an entity might identify customer level costs to recognise costs associated with specific cus-

tomers. Such costs could include specialised equipment or dedicated staff.

DECISION-MAKING EXAMPLE

Selection of appropriate allocation base

SITUATION Multi-million dollar properties backing onto Palm Beach have experienced severe erosion

due to storms and king tides. Some properties have the potential to be completely swept away. The

Gold Coast City Council has a potential repair bill of more than $20 million to stop the properties

being washed into the ocean. Properties will be protected by the construction of artificial reefs and

the restoration of sand dunes. The council will have to find these funds from its budget, which is

partly met by rates paid by local property owners. The question arises how should property owners

contribute towards the repair work?

DECISION Given the potential safety risk, the Council would not be able to ignore this situation.

However, funds would need to be found to pay for the repair work. If the council were to raise the

funds by increasing the annual rates, then the question arises as to how best to do this? Options

available to council would include: a standard levy for all ratepayers; a levy for affected property

owners only; a levy based on property values (either market value or purchase cost); or a different levy

for commercial, residential and vacant land property owners.