ACTIVITY BASED COSTING

Presented By:- Ramanjeet Singh

Jayesh Varun
Vipin Kumar

Ashirdeep Singh
Harsh Kumar

Rahul mattoo

Requirement of Cost Systems

Valuation of the cost of goods sold for financial
reporting.
Estimation of the costs of activities, products,
services.
Providing economic feedback to managers
and operators about process efficiency.

Todays businesses are working in an increasingly

complex environment.
Use of Advanced Technology
Product Life Cycle
Product Complexity
Channels of Distribution
Quality Requirements
Product Diversity

Conventional Costing
Total Cost = Material + Labour+ Overheads
Overheads are allocated to the products on volume
based measures e.g. labour hours, machine hours,
units produced
Will this not distort the costing in the new
environment?

ABC provides an Alternative.

ACTIVITY BASED COSTING

Activity-based costing (ABC) is a costing
methodology that identifies activities in an
organization and assigns the cost of each activity
with resources to all products and services
according to the actual consumption by each.
This model assigns more indirect costs (overhead)
into direct costs compared to conventional
costing.

Conventional Costing
Expenses

AB Costing

Economic
Element

Resources

Activities

Work
Performed

Cost Objects

Product or
service

Cost Objects

Basics of A B C
Cost of a product is the sum of the costs of
all activities required to manufacture and
deliver the product.
Products do not consume costs directly
Money is spent on activities
Activities are consumed by
product/services

Basics of A B C (contd.)
ABC assigns Costs to Products by tracing
expenses to activities. Each Product is charged
based on the extent to which it used an activity

ABC SYSTEMS ADDRESSES THE

FOLLOWING QUESTIONS:
What

activities are being performed by

the organisational resources?
How much does it cost to perform
activities?
Why does the oranisation need to perform
those activities?
How much of each activity is required for
the organisations products, services, and
customers?

TERMINOLOGIES.

Overheads: Overheadis those costs required to

run a business, but which cannot be directly
attributed to any specific business activity,
product, or service.
Examples of overhead are:
Accounting and legal expenses
Administrative salaries
Depreciation
Insurance
Licenses and government fees
Property taxes
Rent
Utilities

Cost Pools: Costs in any one cost pool are attributed

using the same cost driver. A cost pool may relate to an
activity, or a Support cost:
Activity cost pools represent the costs of activities.
There are three main activity cost pools one for
each of Teaching, Research, and Other. Additional
cost pools are needed for sub-activities.
Support cost pools are intermediate holding
places. The costs of a finance department may be
separated into a number of cost pools relating to
payroll, fees, all other areas. A different cost driver is
used for each cost pool (staff time/numbers, all other
costs) when attributing its costs to an activity cost
pool.

 Cost

Drivers: An activity which generates

cost.
A factor such as level of activity or volume
that casually affects cost.
Existence of a cause-and-effect relationship
between a change in the level of activity or
volume and change in the level of total
costs of that cost object.
Thus cost drivers signify factors, forces or
events that determine the costs of activities

NEED OF ACTIVITY BASED

COSTING.
Manufacturing overhead costs have increased
significantly.
The manufacturing overhead costs no longer
correlate with the productive machine hours or
direct labor hours.
The diversity of products and the diversity in
customers' demands have grown.
Some products are produced in large batches,
while others are produced in small batches.
Problem of over-costing and under-costing.

OVER COSTING & UNDER COSTING

Over costing:- A product consumes a relatively

low level of resources but is reported to have a
relatively high total cost.
Under costing : A product consumes a relatively
high level of resources but is reported to have a
relatively low total cost.

UNDER COSTING AND OVER

COSTING EXAMPLE:Ram, Saquib, and harshit order separate items
for lunch which costs: Rams order amounts to
Rs. 14
Saquibs order amounts to Rs. 30
Harshits order amounts to Rs. 16
Total:
Rs. 60
What is average cost per lunch? 60/3 =20

Ram And
Harshit over
costed.

Saquib
under costed

NUMERICAL..

Super manufacturer produces 2 types of products

1. Complex lenses (CL)
2. Simple lenses(SL)

Production:
CL 20000
NL 80000
Manufacturing labor hours = 50000

DIRECT COST
NL
Direct Material = 1520000
Direct labor
= 800000
Total direct cost = 2320000
Direct cost per unit = 2320000/80000 = 29
CL
Direct Material = 920000
Direct labor
= 260000
Total direct cost = 1180000
Direct cost per unit = 1180000/20000 = 59

INDIRECT COST TOTAL 2900000

Conventional method

Cost/labor hour
Cost 2900000/50000
=Rs.58
Super uses 36000 manufacturing
labor-hours to male NL and 14000
direct manufacturing labor-hours to
make CL
CL 14000*58= 812000
NL 36000*58= 2088000

TOTAL COST.
Normal lenses
Direct cost
Rs.2320000+Allocated
2088000
= 4408000

Complex lenses
Direct cost
Rs.1180000 + Allocated
812000 = 1992000

Per unit cost =

4408000/80000=55.1

Per unit cost =

1992000/20000 = 99.6

COST HIERARCHY

In ABC, cost pools are often established for each level in a

hierarchy of costs. For manufacturing firms, the
followingcost hierarchyis commonly identified:
Unit-level costs:For any given product, these costs change
in a more-or-less linear fashion with the number of units
produced. For example, fabric and thread are unit-level costs
for an apparel manufacturer: if the company wants to double
production, it will need twice as much fabric and thread.
Batch-level costs:These costs change in a more-or-less
linear fashion with the number of batches run. Machine setup
costs are often batch-level costs. The time required to prepare
a machine to run one batch of product is usually independent
of the number of units in the batch: the same time is required
to prepare the machine to run a batch of 100 units as a batch
of 50 units. Hence, batch-level costs do not necessarily vary in
a linear fashion with the number of units produced.

Product-level costs:These costs are usually fixed and direct

with respect to a given product. An example is the salary of a
product manager with responsibility for only one product. The
product managers salary is a fixed cost to the company for a wide
range of production volume levels. However, if the company drops
the product entirely, the product manager is no longer needed.
Facility-level costs:These costs are usually fixed and direct
with respect to the facility. An example is property taxes on the
facility, or the salaries of front office personnel such as the
receptionist and office manager.

Cost Hierarchy Category

Facility-level

Activity/Cost
Plant depreciation
Building rent
Management of facility

Product/customer-level

New product development

Product engineering
Product marketing and advertising
Maintaining customer records

Batch-level

Machine setups
Processing purchase orders
Batch quality inspections

Unit-level

Energy to run production machines

Direct labor
Direct materials

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
Manufacturing
costs

Nonmanufacturing
costs

Traditional
product costing

ABC
product costing

ABC assigns both types of costs to products.

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Traditional
product costing

Nonmanufacturing
costs
Mo
st,
not but
all

Some

All

Manufacturing
costs

ABC
product costing

ABC does not assign all manufacturing costs to products.

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING

Level of complexity

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
ActivityBased
ActivityBased
Costing
Costing
Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools

ABC uses more cost pools.

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Each
Each ABC
ABC cost
cost pool
pool has
has its
its
own
own unique
unique measure
measure of
of activity.
activity.
Traditional
Traditional cost
cost systems
systems usually
usually rely
rely
on
on volume
volume measures
measures such
such as
as direct
direct labor
labor
hours
hours and/or
and/or machine
machine hours
hours to
to allocate
allocate
all
all overhead
overhead costs
costs to
to products.
products.
ABC uses more cost pools.

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING

Activity

An event that causes the

consumption of overhead
resources.

Activity
Cost Pool

A cost bucket in which costs

related to a single activity
measure are accumulated.

$$
$
$ $
$

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING

Activity
Activity
Measure
An
An allocation
allocation base
base
in
in an
an activity-based
activity-based
costing
costing system.
system.

The
The term
term cost driver
driver
is also used
used to
to refer
refer
to an
an activity
activity
measure.
measure.

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING
Two common types of activity measures:
Transaction
driver

Duration
driver

Simple count
of the number of
times an activity
occurs.

A measure
of the amount
of time needed
for an activity.

HOW COSTS ARE TREATED UNDER

ACTIVITYBASED COSTING

ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely on
on volume
volume
measures
measures such
such as
as direct
direct labor
labor hours
hours and/or
and/or machine
machine
hours
hours to
to allocate
allocate all
all overhead
overhead costs
costs to
to products.
products.

MERITS OF ABC
Brings accuracy and reliability in product cost
determination by focusing on cause and effect relationship
in the cost incurrence.
Recognizes that activities creates costs , not products
It is product which consumes activities.
ABC provides more realistic product costs in advanced
service or support driven environment
Behavior of many fixed overhead costs in relation to
activities now become more visible and clear.
Helps in reducing costs and identifying activities which
do not add value
Uses multiple cost drivers which are transaction based
rather than volume based

MERITS OF ABC
ABC traces costs to areas of managerial
responsibility, process, customers, department
besides the product costs.
It improves greatly the managers decision
making .
Produce reliable and correct cost data in case of
diversity
Very useful for cost management.
Cost driver rates can be used for design of new /
exixting products as hey indicate overhead costs
that are likely to be applied in costing of the
product.

DEMERITS OF ABC
Complex system
Requires lot of records and tedious calculation
Not suited for small organizations
Sometimes it is difficult to attribute costs to
single activities as some costs support several
activities.
Difficult in implementation
Different level of utility for different firms.
Costly to manage
Only successful if there is total support from top
management.

IMPLEMENTING
ACTIVITY-BASED COSTING
Step 1

Step 2

Identify cost objects.

Identify the direct costs

of the products.

NL
CL

Direct material
Direct labor
Mold cleaning and
maintenance

IMPLEMENTING
ACTIVITY-BASED COSTING
Cleaning and maintenance costs of
360,000 are direct batch-level costs.
Why?
Because these costs consist of workers
wages for cleaning molds after each
batch of lenses is run.

IMPLEMENTING
ACTIVITY-BASED COSTING
Normal Lenses (NL)
Cost Hierarchy
Description
Category
Direct materials
Unit-level
Direct mfg. labor
Unit-level
Cleaning and maint. Batch-level
Total direct costs

1,520,000
800,000
160,000
2,480,000

IMPLEMENTING
ACTIVITY-BASED COSTING

Complex Lenses (CL)

Cost Hierarchy
Description
Category
Direct materials
Unit-level
920,000
Direct mfg. labor
Unit-level
260,000
Cleaning and maint. Batch-level
200,000
Total direct costs
1,380,000

IMPLEMENTING
ACTIVITY-BASED COSTING
Step 3
Select the cost-allocation bases to use for
allocating indirect costs to the products.
(1)
Activity
Design
Setups
Operations

(2)
Cost Hierarchy
Product-sustaining
Batch-level
Unit-level

(3)
Total Costs
450,000
409,200
637,500

IMPLEMENTING
ACTIVITY-BASED COSTING
Step 4
Identify the indirect costs associated
with each cost-allocation base.
Overhead costs incurred are assigned
to activities, to the extent possible, on
the basis of a cause-and-effect relationship.

IMPLEMENTING
ACTIVITY-BASED COSTING
Step 5
Compute the rate per unit.

Setup-hours:

(1)
NL
640

CL
2,000

409,200 2,640 = 155

(5)
Total
2,640

IMPLEMENTING
ACTIVITY-BASED COSTING
Step 6
Compute the indirect costs allocated
to the products.
NL: 155 640 =
CL: 155 2,000 =
Total

99,200
310,000
409,200

IMPLEMENTING
ACTIVITY-BASED COSTING
Step 7
Compute the costs of the products.
NL and CL would show three
direct cost categories.
1.

Direct materials

2.

Direct manufacturing labor

3.

Cleaning and maintenance

IMPLEMENTING
ACTIVITY-BASED COSTING
NL and CL would show six indirect cost pools.
1.

Design

2.

Molding machine setups

3.

Manufacturing operations

4.

Shipment setup

5.

Distribution

6.

Administration

ACTIVITY-BASED MANAGEMENT
Activity-based management (ABM)is a method of
identifying and evaluating activities that a
business performs usingactivity-based costingto
carry out avalue chainanalysis or a reengineering initiative to improve strategic and
operational decisions in an organization.
Activity-based costingestablishes relationships
betweenoverhead costsand activities so that
overhead costs can be more precisely allocated to
products, services, or customer segments.
Activity-based management focuses on managing
activities to reduce costs and improve customer
value.

TYPES OF ABM
Operational ABMis about doing things right,
using ABC information to improve efficiency.
Those activities which add value to the product
can be identified and improved. Activities that
dont add value are the ones that need to be
reduced to cut costs without reducing product
value.
Strategic ABMis about doing the right things,
using ABC information to decide which products
to develop and which activities to use. This can
also be used for customer profitability analysis,
identifying which customers are the most
profitable and focusing on them more.

EVALUATION OF ABM
The benefits of ABM (and ABC) are greatest in
organisations that have high indirect costs.
Users of ABM and ABC often assume that all
overhead costs are variable. This is not the case,
and some overhead costs will be fixed, so will not
be saved if activities are reduced.
ABM is also complex and is expensive to
implement. For small businesses, or businesses
with narrow product ranges, the benefits of
implementing ABM may not justify the costs.

RISK ANALYSIS
A risk with ABM is that some activities have an
implicit value, not necessarily reflected in a
financial value added to any product.
For instance a particularly pleasant workplace
can help attract and retain the best staff, but
may not be identified as adding value in
operational ABM.
A customer that represents a loss based on
committed activities, but that opens up leads in a
new market, may be identified as a low value
customer by a strategic ABM process.