Activity Based Costing - an introduction

7/30/2019 Activity Based Costing - an introduction

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BETTER COSTING FOR BETTER DECISIONS

Activity-Based Costing

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Learning Objectives

Distinguish between the traditional and theactivity-based costing approaches.

Evaluate the costs and benefits ofimplementing activity-based costingsystems.


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Requirement of Cost Systems

Valuation of inventory and measurement of

the cost of goods sold for financial reporting.

Estimation of the costs of activities,products, services, and customers.

Providing economic feedback tomanagers and operators about processefficiency.


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INDIRECT COSTSNot easily and conveniently traceable to

cost objects

Cost element is shared among cost objects

Physically impossible to trace

Not cost effective to trace

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INDIRECT COSTS

Need for allocation

Estimate product or activity cost

What does it really cost?

Increase awareness of indirect costsActivities are not free

Plan more cost efficient operations

Now that we know what it costs, what should wedo?

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TRADITIONAL ALLOCATION METHOD

Indirect costs allocated to cost objectbased on the cost objects consumptionof some measure of activity, usually labor

hours

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$10,000,000 total indirect cost400,000 total labor hours

= $25 per hour rate

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


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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.


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ACTIVITY-BASED COSTING

Traditional allocation method

Activity-based allocation method

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Costs Products

Costs ProductsActivities

First stage Second stage


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Basics of A B C

Cost of a product is the sum of the costsof 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


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OVERVIEW OF ABC

Identifies activities required to producethe product or service

Determines the cost of the activities

Allocates costs to the cost object basedon the objects consumption of activities

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Basics of A B C (contd.)

ABC assigns Costs to Products by tracingexpenses to activities. Each Product is

charged based on the extent to which it usedan activity

The primary objective of ABC is to assigncosts that reflect/mirror the physical dynamicsof the business


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Basics of A B C (contd.)

Provides ways of assigning the costs ofindirect support resources to activities,

business processes, customers, products. It recognises that many organisational

resources are required not for physicalproduction of units of product but to provide a

broad array of support activities.


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Basics of A B C : How?

Steps:

1. Form cost pools

2. Identify activities

3. Map resource costs to activities

4. Define activity cost drivers5. Calculate cost

Cost pools are groups orcategories ofindividualexpense items


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IMPLICATIONS OF ABC/ABM

Shifts focus from managingcosts to managing activities

Aids in recognizing, measuring

and controlling complexity Promotes understanding of why

costs are incurred

Provides better cost allocationinformation

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IMPLICATIONS OF ABC/ABM

Useful for planning futureoperations

Fosters continuous improvement

Likely to meet with substantialresistance

Analysis ofwhy and how activitiesare performed

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Existing Single Indirect-

Cost Pool System Example

Kole Corporation manufactures a normal lens(NL) and a complex lens (CL).

Kole currently uses a single indirect-cost ratejob costing system.

Cost objects: 80,000 (NL) and 20,000 (CL).


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NL CL

Direct Material 1,520,000 920,000

Direct Manuf.Labour

800,000 260,000

No. of Units 80,000 20,000

Manuf. LaborHrs

36,000 14000

Selling Price 60 142

How much indirect costs are allocatedto each product and what is profit margin?Total indirect Cost is 2900,000 which is to be allocatedon the basis of direct manufacturing Labour Hrs used.


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Normal Lenses (NL)

Direct materials $1,520,000Direct mfg. labor 800,000Total direct costs 2,320,000

Direct cost per unit: $2,320,000 80,000 = $29


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Complex Lenses (CL)

Direct materials $ 920,000Direct mfg. labor 260,000Total direct costs $1,180,000

Direct cost per unit: $1,180,000 20,000 = $59


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All Indirect Costs$2,900,000

50,000 DirectManufacturingLabor-Hours

INDIRECT-COSTPOLL

INDIRECTCOST-ALLOCATIONBASE

$58 per DirectManufacturing

Labor-Hour


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Indirect Costs

Direct Costs

COST OBJECT:NL AND CL

LENSES

DIRECTCOSTS

DirectMaterials

DirectManufacturing

Labor


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What is the total cost of complex lenses?

Direct costs $1,180,000 + Allocated costs$812,000 = $1,992,000

What is the cost per unit?

$1,992,000 20,000 = $99.60


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Normal lenses sell for $60 each andcomplex lenses for $142 each.

Normal ComplexRevenue $60.00 $142.00Cost 55.10 99.60Income $ 4.90 $ 42.40Margin 8.2% 29.9%


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ABC COSTING

Activity identified:-

1. Design o f Produc ts and Process

2. Setup & Manu factu r ing Operat ions

3. Shipp ing and Distr ibut ion

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Refining a Costing System

1. Design of Products and Process

The Design Department designs the moldsand defines processes needed (details of

the manufacturing operations).


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Refining a Costing System

2. Setup & Manufacturing Operations

Lenses are molded, finished,cleaned, and inspected.

3. Shipping and Distribution

Finished lenses are packed andsent to the various customers.


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Activity-Based Costing System

No. ofSetupHours

LensesNL

LensesCL

LensesOther

CostAllocationBase

ProductCostObjects

No. ofShipments

Parts-Square

feet

SetupDesign ShippingActivityIndirect CostPool


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Consumption of Indirect Cost $2900000 asper activity.

Activities Total cost Cost allocationbase

Design $1800000 100 Parts squarefeet

Set up $409,200 2640 Setup-hours

Shipment $690800 200 Shipments

A ti it B d C ti S t


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Calculate cost of production per unit as per ABC fromgiven information.

NL CL Total

Quantity produced 80,000 20,000 100000

No. of unit/batch 250 50

Number of batches 320 400 720

Setup time per batch 2 hrs 5 hrs

Total setup-hours 640 2,000 2640

Total parts sq. ft. used 30 70 100

Total no. of Shipments 100 100 200


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What is the design cost per square feet?

$1800000 100 Sq. Ft = $18000What is the setup cost per setup-hour?

$409,200 2,640 hours = $155


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What is the shipping cost per shipment?$690800 200 = $3454

Allocation of cost for design departmentusing parts square feet :

NL: $18000 30 = $ 540000

CL: $18000 70 = $1260000Total $1800000


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Output Unit-Level Costs

Allocation of cost for set up departmentusing setup-hours:

NL: $155 640 = $ 99,200

CL: $155 2,000 = $310,000Total $409,200

Allocation of cost for shipping departmentusing no. of shipment:

NL: $3454 100 = $ 345400CL: $3454 100 = $ 345400Total $690800


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Product-Sustaining Costs

Total cost of NLPrime cost- $2,320,000

Design department- $540000Set up department- $99200Shipping department-$345400

Total cost- $3304600

Unit cost of NL is $41.31



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Facility-Sustaining Costs

Total cost of CLPrime cost- $1,180,000Design department- $1260000Set up department- $310,000Shipping department-$345400


Unit cost of CL is $154.77

Profit from NL=$18.69Profit margin= 31.15%

Profit from CL=-$12.77Profit margin= -8.99%


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Benefits of ABC Systems

Significant amounts of indirect costs areallocated using only one or two cost pools.

All or most costs are identifiedas output unit-level costs.

Products make diverse demands on

resources because of differences involume, process steps, batch size,

or complexity.


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Benefits of ABC Systems

Operations staff have significant

disagreements with the accountingstaff about the costs of manufacturingand marketing products and services.


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Limitations of ABC Systems

The main limitations of ABC are the

measurements necessary toimplement the system.

ABC systems require managementto estimate costs of activity poolsand to identify and measure cost

drivers for these pools.


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Learnings

Distinguish between the traditional and theactivity-based costing approaches.

Evaluate the costs and benefits ofimplementing activity-based costingsystems.


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Any Question

Thanx

Documents

Activity Based Costing - an introduction