ACTIVITY BASED COSTING

Presented by: PRN 14, 26, 27, 30, 35, 41, 59

CONTENT
Traditional Costing Methods Activity Based Costing (ABC) How does ABC works Implementation of ABC Advantages of ABC Disadvantages of ABC Example ABC in service industries References

TRADITIONAL COSTING METHODS

Spreads overhead cost over entire customer base Each order appears to cost the same Orders with high profit margins subsidize orders with low profit margins A single or plant-wide rate called a predetermined overhead rate is used: Job Order = Direct Labor Costs Process Cost = Machine Hours

TRADITIONAL ALLOCATION METHOD

Indirect costs allocated to cost object based on the cost objects consumption of some measure of activity, usually labor hours
$10,000,000 total indirect cost = $25 per hour rate 400,000 total labor hours

A product consuming 6 labor hours would be charged $150 of indirect costs

CRITICISMS OF TRADITIONAL OVERHEAD ALLOCATION

Assumes all overhead is volume-related Factory-wide or departmental rates

All related to single activity measure

Departmental focus, not process focus Focus on costs incurred, not cause of costs

NEED FOR A NEW SYSTEM

Amount of direct labor used in many industries has decreased Total overhead from depreciation on equipment, utilities, repairs, maintenance has increased

ACTIVITY-BASED COSTING

Traditional allocation method

Costs Products

Activity-based allocation method

Costs
First stage

Activities

Products
Second stage

ACTIVITY-BASED COSTING

Activity based costing says that something has to be allocated Kaplan, 1989 ABC is a concept around which it can construct an economic model of its business that will provide the accurate and relevant cost information necessary to support sound business decisions of all types Hicks, 1999 Activity Based Costing is 30% understanding and using techniques correctly, and 70% the ability to convince others to accept beneficial change. No matter how brilliant the measurement, if people reject it, nothing has been achieved and the analyst has failed - Ralf Sorenson (Head of SAS Airlines)

LEVELS OF COST INCURRENCE (SPECIFIC TO MANUFACTURING SECTOR)

Not all costs are volume-related

Unit level Batch level Product level Facility level

Exhibit 1

ABC systems commonly use the above four-part cost hierarchy to identify cost-allocation bases

HOW DOES

ABC WORK?

Identification of cost pools or activities which a product/service must pass. Estimation of total cost of each activity must be estimated for time period. Estimation of number of hours spent on each activity for same time period. Determination and assigning of cost driver (i.e. quantity, # of labor hours, # of machine hours, # of parts). Any factor or activity that has a direct cause-effect relationship with the resources consumed. In ABC cost drivers are used to assign activity cost pools to products or services.

BUILDING AN ABC MODEL

Identify Resources Identify Activities Identify Cost Objects

Define Activity Drivers

Define Resource Drivers

Enter Resource Costs

Enter Resource Driver Qty.

Enter Activity Driver Qty.

Calculate Costs

BUILDING AN ABC MODEL

IMPLEMENTING ABC

Step 1 Plan the system What are the goals? Inventory valuation Process improvement Foster active involvement Assemble cross-functional team Functional specialists

IMPLEMENTING ABC

Step 2 Define, analyze activities and resources Decompose organization into elemental activities Who does what, and why? Interview employees Determine resources Determine inputs and outputs

IMPLEMENTING ABC

Step 3 Establish activity cost pools and determine first stage allocation First stage allocations assign costs to cost pools Requires costs to be re-categorized according to why they are incurred, not by type Drivers may be employee time, square footage, etc.

IMPLEMENTING ABC

Step 4 Determine second stage drivers and assign costs to cost objects Outputs of activity analysis may be second stage drivers Distance moved, times handled, machine hours, units, etc. Amount assigned to the cost object is the amount of activity consumed times the rate per unit of the activity

ABC

IS USEFUL WHEN

High amounts of overhead cost Multiple products Complex products Complex production system Significant variation in volume between high and low volume products Different products place different demands on resources Problems with current cost allocations due to changes in products or processes Better cost information is needed

DISADVANTAGES

More time consuming to collect data Cost of buying, implementing and maintaining activity based system Makes waste visible which some executives and managers don't want their boss to see Even in activity-based costing, some overhead costs are difficult to assign to products and customers, such as the chief executive's salary. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed.

EXAMPLE
Product Annual Output (units) 5,000 60,000 Total Machine Hours 20,000 1,20,000 Total no. of Total No. purchase of set-ups orders 160 384 20 44

A B

The annual overheads are as under: Volume related activity costs: Set-up related costs: Purchase related costs: Rs. 5,50,000 Rs. 8,20,000 Rs. 6,18,000

EXAMPLE
(a) Traditional method of charging overheads:

Volume related activity costs: Set-up related costs: Purchased related costs: Total Costs:

Rs. 5,50,000 Rs. 8,20,000 Rs. 6,18,000 Rs. 19,88,000

= 1,40,000 = Rs. 14.20 = Rs. 56.80 = Rs. 29.40

Total Machine hours (20,000 + 1,20,000) Total cost per hour (Rs. 19,88,000/1,40,000) Cost per unit A = (20,000 X Rs. 14.20)/5,000 Cost per unit B = (1,20,000 X Rs. 14.20)/60,000

EXAMPLE
(b) Activity Based Costing method of charging overheads: Volume related activity cost per machine hours = Rs. 5,50,000/1,40,000 = Rs. 3.9286 Set-up related costs per set-up = Rs. 8,20,000/64 = Rs. 12,812.50 Purchased related costs per purchase order = Rs. 6,18,000/544 = Rs. 1136.029
Particulars
Volume Related Cost Set-up Costs Purchase related costs Cost per unit

Cost Driver
Machine Hours No. of set-ups No. of Purchase orders

A
Rs. 78,572 Rs. 2,56,240 Rs. 1,81,765

B
Rs. 4,71,432 Rs. 5,63,728 Rs. 4,36,235 Rs. 14,71,395 Rs. 24.52

Total Costs Rs. 5,16,577 Rs. 103.32

EXAMPLE

A Traditional Method Activity Based Costing Rs. 56.80 Rs. 103.32

B Rs. 28.40 Rs. 24.52

Total Cost Rs. 19,88,000 Rs. 19,87,800

ABC IN SERVICE INDUSTRY

Service firms are becoming more interested in costing accurately in order to make long- term strategic decisions as well as day-to-day operating decisions. Accurate costs are necessary to make product pricing, staffing, and resource allocation decisions. Accurate costs, along with the quantity and patterns of resource consumption, let managers know the proper price to charge for services.

ABC IN SERVICE INDUSTRY

Costing in the service sector needs to be forwardlooking. They need to find out: Which products are profitable Which products should be emphasized Trends in product profitability over time Product costs as a basis for setting prices

ABC IN SERVICE INDUSTRY FINANCIAL SECTOR

Banking costs are not driven by the volume of customers, but rather the number of transactions processed. Traditional volume based costing is obviously inappropriate in this case. Banks are moving to the concept where the user pays for the cost of the services they use, so that all users do not share the bill evenly. To do so they must have an accurate reflection of the cost of services.

ABC IN SERVICE INDUSTRY FINANCIAL SECTOR

Step-by-step how banks should implement ABC1:

Split the bank into profit centers. Prepare a list of products associated with each profit center and a list of product related and non-product related activities. Divide non-product related activities into activities with unit-specific significance and activities with organization-wide significance. The former activities are spread across all products produced by the unit. The latter category should include as few things as possible.

CASE IMPLEMENTATION OF ABC SCALE INDUSTRY

IN

SMALL

Tool & Die Inc., Western Pennsylvania

REFERENCES

Jawahar Lal and Seema Srivastava, Cost Accounting (4E), Tata McGraw-Hill http://en.wikipedia.org/wiki/Activity-based_costing, last viewed on 24.01.2011 http://maaw.info/ArticleSummaries/ArtSumRuhlHartman98. htm, last viewed on 22.01.2011 1: Sharma, V. 1992. Determining product profitability. The Bankers Magazine. Narcyz Roztocki and Kim LaScola Needy, A Procedure for Smooth Implementation of Activity Based Costing in Small Companies.

Thank You !!!

APPENDIX A COST DRIVERS

No. of receiving orders for the receiving department. No. of purchase orders for the cost of operating the purchase departments. No. of units. No. of setups. No. of inspections. No. of set up hours. No. of vendors. No. of parts No. customer order processed. No. of employees.

EXHIBIT 1 : ACTIVITY LEVELS & ASSOCIATED ACTIVITY COSTS

Activity Level 1. Unit Level Reason for Activity Performed for each unit of product produced/sold. Performed for each batch of product produced/sold. Performed to support each different product that can be produced. Performed to maintain general manufacturing capabilities. Example of Activity Cost
Cost of raw materials. Cost of inserting a component. Sales Commission. Cost of processing sales order. Cost of inspection. Cost of equipment setup. Cost of product development. Cost of specialized equipment. Cost of real property taxes. Cost of general advertising. Cos of non-specialised equipments.

2. Batch Level

3. Product Level

4. Facility Level