Activity Based Costing

- Harini S.

Objectives of this session

Approaches to cost allocation Need for Activity Based Costing (ABC) Basics Problems and solutions Advantages of ABC Pitfalls and challenges Case discussions

Objectives of this session

Approaches to cost allocation a. Basic definitions b. Ways of allocating costs Need for Activity Based Costing (ABC)

Basics
Problems and solutions Advantages of ABC

Pitfalls and challenges

Case discussions

The traditional methods of allocating costs use blanket rates at the plant or department level
Cost Object Item for which cost measurement is required Cost Driver Factor that causes a change in the costs of the activity; can be a resource cost driver or activity cost driver Direct cost items: Direct labor (use actual employee rates) Raw material Purchased components Outsourced manufacturing services Support cost items Research & Development Customer service

Single Plant-wide Overhead rate

assumes all overheads are volume related

Multiple Department Rate

Single activity measure Focus on departmental costs rather than on the causes

Activity Based Costing

Objectives of this session

Approaches to cost allocation Need for Activity Based Costing (ABC) a.Origin of ABC thought b.When and why ABC?

Basics
Problems and solutions Advantages of ABC

Pitfalls and challenges

Case discussions

Origin of ABC thought

Accounting Lag: The Obsolescence of Cost Accounting Systems
(Kaplan, 1985)
I had hoped to be able to document the incidence and value of innovative accounting and control systems for the new industrial competition I found that changes in accounting lag far behind changes in the real production phenomena they are supposed to represent.

to learn how firms are modifying their accounting and control systems to help them manage in the new manufacturing environment, I visited a select set of innovative firms.

One company reorganized manufacturing to create a smooth production flow, butbenefits from reorganization were impossible to quantify the

accounting system accumulated only total project costs there was no way to compute productivity measures or unit costs for items being produced using the new manufacturing philosophy

Two companies implemented JIT and total quality managementBut continued to use a standard costing system that allocated all costs based on often obsolete direct labor costs, even though direct labor represented less than 10 percent of total manufacturing cost.

When and why ABC?

When there is great diversity in the product range When production overheads are high in relation to direct costs When products use very different amounts of overhead resources When consumption of overheads by different departments is not based on volumes To estimate the accurate cost of product or service for bidding / price fixing To increase awareness about indirect costs in the manufacturing process To reduce and eliminate inefficiencies after identifying them To carry out better accounting of complex products

Objectives of this session

Approaches to cost allocation Need for Activity Based Costing (ABC) Basics Problems and solutions Advantages of ABC Pitfalls and challenges Case discussions

5 stages of ABC
Identifying different activities in an organization Relating the overheads to distinct activities Determination of cost drivers Create cost pools to collect the activity costs having the same cost driver Calculation of activity cost driver rates and attribution of costs to products and services

Examples of Activities
Unit-level Activities are performed each time a unit is produced or sold. Batch-level Activities are performed when a group or batch is produced. Product-level Activities are required to maintain a particular product or service. Customer-level Activities are required to service a particular customer or channel of distribution.

Facilities-level Activities are required to support a specific plant or business site.

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Defining activity drivers is a crucial step

Activities Drivers Unit Level Acquire and Use material for containers No. of Containers Acquire and Use material for baby-care productsproducts No. of Batch Level Set up manually controlled machines Set up computer controlled machines Product Level Design and manufacture moulds Use manually controlled machines Use conputer controlled machines Customer Level Consult customers Provide warehousing for customers

No. of batches of containers No. of batches of B. Produst

No.of moulds required Product type (containers) Product type (B.Products)

No. of consultations No. of cubit feet

Faciltiy Level Manage workers

Salaries

Objectives of this session

Approaches to cost allocation Need for Activity Based Costing (ABC) Basics Problems and solutions Advantages of ABC Pitfalls and challenges Case discussions

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Problem on ABC
ABC is a multiproduct company, manufacturing 3 products A, B and C. The budgeted costs and production for the year ending 31st March, 2004 are as follows. The budgeted direct labour rate was Rs.10 per hour and materials cost was Rs.2 per kg. Production overheads were budgeted at Rs.99450 and were absorbed to products using direct labour rate. ABC is now considering to adopt ABC. The following additional info is available: Budgeted overheads were analysed into the following: a. Material handling Cost driver: wt of materials handled Rs.29100 b. Storage costs Number of batches of material Rs.31200 c. Electricity Number of machine operations Rs.39150

A Production qnty (units) Direct Materials (kg) Direct Labour (minutes) For complete prod, batches of materials required Number of machine operations per unit 4000 4 30 10 6

B 3000 6 45 5 3

C 1600 3 60 15 2

Objectives of this session

Approaches to cost allocation Need for Activity Based Costing (ABC) Basics Problems and solutions Advantages of ABC Pitfalls and challenges Case discussions

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Advantages of ABC
Helps understand the behavior of overhead costs and their relationships of products, services, customers and market segments Helps allocate resources to those activities, that will increase shareholders value Links profitability analysis to operational decisions

Ensures that the cost of non-value added activities is visible to the management
Provides right information for performance measurement because it focuses on activities rather than resources

Objectives of this session

Approaches to cost allocation Need for Activity Based Costing (ABC) Basics Problems and solutions Advantages of ABC Pitfalls and challenges Case discussions

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Pitfalls and challenges

Absorbs a lot of resources Doesnt consider opportunity costs Time consuming process Has been replaced by more advanced approaches

Objectives of this session

Approaches to cost allocation Need for Activity Based Costing (ABC) Basics Problems and solutions Advantages of ABC Pitfalls and challenges Case discussions

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Field Work and Cases

Beyond Products e.g., costs of customers
Kanthal (Kaplan, 1989) [Bobs #1 most popular case] Cooperative Bank (Datar & Kaplan, 1995) [#4 most popular] Dakota Office Products (Kaplan, 2001) Owens and Minor (Narayanan & Brem, 2002)

Beyond Costing Activity-based Management

Texas Instruments (Ittner & Kaplan, 1988) Indianapolis City Services (Kaplan, 1996) [#7 most popular]

Articulation of the ABC model

One cost system isnt enough (Kaplan, HBR 1988) Measure costs right: Make the right decisions (Cooper and Kaplan,
HBR 1988)

Contribution margin analysis: No longer relevant/ Strategic cost management: The New Paradigm (Kaplan, JMAR 1990) Profit priorities from activity-based costing (Cooper and Kaplan,
HBR 1991)

Activity-based systems: Measuring the costs of resource usage (Cooper and Kaplan, AH 1992)

Implementing ABC
Evaluating the Impact of ABC Implementation
Case and Field studies The impact of contextual and process factors on the evaluation of activity based costing systems (Anderson & Young, 1999) Factors influencing the performance of activity based costing teams (Anderson, Hesford & Young, 2002) Large sample: surveys and archival financial data Measuring the success of activity-based cost management and its determinants (Foster & Swenson 1997) The association between activity-based costing and manufacturing performance (Ittner, Lanen & Larcker, 2002) The impact of ABC techniques on firm performance (Kennedy & The association between ABC and improvement in financial performance (Cagwin & Bouwman, 2002)
Affleck-Graves, 2001)

Thank you.