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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin ACTIVITY-BASED COSTING Ankur Verma Abhinav Parmar Arvinderpal

Activity based costing

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Page 1: Activity based costing

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

ACTIVITY-BASED COSTING

Ankur Verma

Abhinav Parmar

Arvinderpal

ACTIVITY-BASED COSTING

Ankur Verma

Abhinav Parmar

Arvinderpal

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ACTIVITY BASED COSTING Traditional costing system ABC System1. Direct and indirect costs 1. The direct and indirect costs are are allocated to process allocated to activities like centres or major departments Purchases, Material handling,

Producing the goods, machine set ups, Supervising production workers, Inspecting finished

goods, Dispatching good to customers 2. Cost driver as base for 2.Cost driver as base for allocation allocation of overheads is not of overheads is based on causebased on cause and effect and effect relationship between relationship overheads and the overhead allocation base (the cost driver) Stores deptt – Labour hours or machine hours or units produced3. There is only one cost 3. There are many allocation bases

driver Or OH allocation as per activity chosen and cause

and effect base relationship

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Traditional, Volume-Based Product-Costing System

• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.

• The following information is obtained from company records:

Mode I Mode I I Mode I I IProduction: Units 10,000 20,000 4,000 Runs 1 run of 10,000

units 4 runs of

5,000 units 10 runs of 400 units

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Traditional, Volume-Based Product-Costing System

Additional information includes:

Mode I Mode I I Mode I I IDirect materials 50.00$ 90.00$ 20.00$ Direct labor (hr/board) 3 4 2 Setup time (hr/run) 10 10 10 Machine time (hr/board) 1 1.25 2

M o d e I M o d e I I M o d e I I ID i r e c t m a t e r i a l s 5 0 . 0 0$ 9 0 . 0 0$ 2 0 . 0 0$ D i r e c t l a b o r 6 0 . 0 0 8 0 . 0 0 4 0 . 0 0 B u d g e t e d m a n u f a c t u r i n g o v e r h e a d $ 3 , 8 9 4 , 0 0 0

Manufacturing overhead is determined as follows

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Traditional, Volume-Based Product-Costing System

Mode I Mode I I Mode I I IUnits produced 10,000 20,000 4,000 Direct labor (hr/unit) 3 4 2 Total hours 30,000 80,000 8,000

Total hours required 118,000

Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours 118,000

= $33 per hour

M o d e I M o d e I I M o d e I I ID i r e c t l a b o r ( h r / u n i t ) 3 4 2 O v e r h e a d r a t e p e r h o u r 3 3$ 3 3$ 3 3$ O v e r h e a d p e r u n i t 9 9$ 1 3 2$ 6 6$

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Traditional, Volume-Based Product-Costing System

With these product costs, Aerotech established target selling prices (Cost × 125%).

Mode I Mode I I Mode I I IDirect materials 50.00$ 90.00$ 20.00$ Direct labor 60.00 80.00 40.00 Manufacturing overhead 99.00 132.00 66.00 Total 209.00$ 302.00$ 126.00$

Mode I Mode I I Mode I I ICost per unit 209.00$ 302.00$ 126.00$ Target selling price 261.25 377.50 157.50

209.00 x 1.25

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Activity Based Costing System (ABC)

ABC systems follow a two-

stage procedure to assign

overhead costs to products.

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Activity Based Costing System (ABC)

ABC systems follow a two-stage procedure to assign overhead costs to products.

Stage OneIdentify significant

activities and assign overheadcosts to each activity in

proportion to resources used.

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Activity Based Costing System (ABC)

Stage TwoIdentify cost drivers

appropriate to each activityand allocate overhead to

the products.

ABC systems follow a two-stage procedure to assign overhead costs to products.

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ABC System

1. Identify major activities

activity consists of aggregation of tasks having common characteristics)

e.g. Activity: purchase of materials :

Tasks: receiving a purchase request, inviting quotations, selecting supplier, placing orders, receiving material

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2. Assigning costs to Activity Cost Centers:

Cost incurred on these activities are

assigned to these Activity Cost Centers.

Direct costs are traced directly.

Indirect costs are assigned to activities on the

basis of cause and effect cost drivers.

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There must be a cause - effect relationship between the overheads to be allocated and the allocation base otherwise inaccurate allocation of overheads will occur.

For an example, it would be wrong to allocate overheads of stores dept. on the basis of labor hours.

It should be more appropriately based on number of units handled or used in production process.

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3. Selecting cost drivers for allocating costs to cost objects

The costs accumulated for an activity cost centre

are then allocated to different cost objects.

For this, a separate activity cost driver or allocation rate is used.

In ABC analysis, the tracing of overheads to cost objects requires that cost behavior must be understood so that appropriate cost drivers are identified.

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Identifying activities and cost driversdepends upon type of activity, Volume related or not volume related

Major activity

1. Processing orders for Purchase of materials/ Stores

2. Handling materials and Parts

3. Inspection of material and parts purchased

4. Setting up production procedures

Associated costs

1. Labor cost of employees working in purchase dept. 2. Labor cost of stores, depreciation of machines used for moving materials 3. Labor cost of inspection team, Depr. Of testing equipments 4. Labor cost of works involved in set-ups and depr. of set up equipments

Cost drivers

1. No. of purchase orders processed

2. No. of materials and parts requisitions

3. No. of receipts of materials and parts

4. No. of set ups

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Identifying activities and cost driversDepends upon type of activity, Volume related or not volume related

Major activity

5. Producing the goods

6. Supervising production workers

7. Inspecting finished goods

8. Dispatching good to customers

Associated costs

5. Depreciation of machines

6. Salary of assembly supervisors

7. Labor cost of inspectors and depreciation of test equipments

8. Labor cost of packing and cost ofPacking materials

Cost drivers

5. No. of machine hours

6. No. of assembly labor hours

7. No. of inspections

8. No. of boxes packed

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Two Key Points

A large proportion of non-unit-level activities

A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately.

Product diversity

When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

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Cost Drivers

A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost

driver, we must consider . . .

Degree ofCorrelation

Cost ofMeasurement

BehavioralEffects

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Direct versus Indirect Costs

Volume-Based Costing

All production costs except direct

materials and direct labor are lumped together in one

overhead cost pool.

Activity-Based Costing

An effort is made to account for as many costs as possible as

direct costs of production.

IndirectCosts

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Interviewing and Paper Trails

The information for ABC systems initially comes from interviews with employees in the support departments and a review of each department’s records.

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Storyboarding

A procedure used to develop a detailed process flow chart, which visually

represents activities and the relationships among activities.

Step1

Step2

Step3

Step4

These are the steps wefollow to build amemory board.

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Machinerycost pool

Maintenance

Depreciation

Computer Support

Lubrication

Electricity

Calibration

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Engineeringcost pool

Engineering salaries Engineering software

Engineering supplies Depreciation

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Property taxes

Insurance

Security

Plant depr.

Plant mgmt.

Plant maint.

Facilitycost pool

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Overhead CostsTotal budgeted cost = $3,894,000

ActivityCostPools

Machinerycost pool

$1,212,600

Setupcost pool

$3,000

Engineeringcost pool$700,000

Facilitycost pool$507,400

UnitLevel

BatchLevel

Product-Sustaining

Level

FacilityLevel

Identificationof ActivityCost Pools

Activitymust bedone oneach unitproduced.

Activityperformedon eachbatch

produced.

Activities needed to supportan entire product line

Activity required in orderfor the productionprocess to occur.

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Receiving/Inspectioncost pool $200,000

Material-Handlingcost pool $600,000

Quality-Assurancecost pool $421,000

Packaging/Shippingcost pool $250,000

Machinerycost pool

$1,212,600

Setupcost pool

$3,000

Engineeringcost pool$700,000

Facilitycost pool$507,400

UnitLevel

BatchLevel

Product-Sustaining

LevelFacilityLevel

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Machinery Cost PoolTotal budgeted cost = $1,212,600

Maintenance

Depreciation

Computer Support

Lubrication

Electricity

Calibration

Activitycostpool

STAGE ONE

Various overheadcosts relatedto machinery

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Calculatethe pool

rate

Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours 43,000 $28.20/hour

CostAssignment

STAGE TWO

=

=

Mode I:$28.20 per hr.

1 hr. per unit$28.20 per unit

Mode II:$28.20 per hr.

1.25 hr. per unit$35.25 per unit

Mode III:$28.20 per hr.

2 hr. per unit$56.40 per unit

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Calculation oftotal setup cost

Setup Cost PoolTotal budgeted cost = $3,000

Activitycostpool

STAGE ONE

Total budgeted setup cost$20 per hour10 hr. per setup

$200 cost per setup15 production runs

3,000$ Total

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Calculatethe pool

rate

Budgeted Setup Costs $3,000Planned Production Runs 15 runs $200 per run

CostAssignment

STAGE TWO

=

=

Mode I: (1 Run)

= $.02 per unit

$200 per run10,000 units per run

Mode II: (4 Runs)

= $.04 per unit

$200 per run5,000 units per run

Mode III: (10 Runs)

= $.50 per unit

$200 per run400 units per run

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Various overheadcosts related

to engineering

Engineering salaries

Engineering supplies

Engineering software

Depreciation

Engineering Cost PoolTotal budgeted cost = $700,000

Activitycostpool

STAGE ONE

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Allocate basedon engineering

transactions

CostAssignment

STAGE TWO

Engineering Cost PoolTotal budgeted cost = $700,000

Mode I:

= $17.50 per unit

25% × $700,00010,000 units

Mode II:

= $15.75 per unit

45% × $700,00020,000 units

Mode III:

= $52.50 per unit

30% × $700,0004,000 units

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Exh.5-9

Various overheadcosts related

to generaloperations

Plant depr.

Plant mgmt.

Plant maint.

Property taxes

Insurance

Security

Facility Cost PoolTotal budgeted cost = $507,400

Activitycostpool

STAGE ONE

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Exh.5-9

Budgeted Facilities Cost $507,400Budgeted Direct-Labor Hours 118,000 $4.30/hour

CostAssignment

STAGE TWO

=

=

Mode I:$4.30 per hr.

× 3 hr. per unit$12.90 per unit

Mode II:$4.30 per hr.

× 4 hr. per unit$17.20 per unit

Mode III:$4.30 per hr.

× 2 hr. per unit$8.60 per unit

Calculatethe pool

rate

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Other Overhead Costs

Board Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

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Board Overhead × % ÷ Units = Cost/UnitMode I 250,000$ × 4% ÷ 10,000 = 1.00$ Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 421,000$ × 20% ÷ 10,000 = 8.42$ Mode II 421,000 × 40% ÷ 20,000 = 8.42 Mode III 421,000 × 40% ÷ 4,000 = 42.10

Quality-Assurance Cost Pool

Other Overhead Costs

Board Overhead × % ÷ Units = Cost/UnitMode I 200,000$ × 6% ÷ 10,000 = 1.20$ Mode II 200,000 × 24% ÷ 20,000 = 2.40 Mode III 200,000 × 70% ÷ 4,000 = 35.00

Receiving and Inspection Cost Pool

Board Overhead × % ÷ Units = Cost/UnitMode I 600,000$ × 7% ÷ 10,000 = 4.20$ Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50

Material-Handling Cost Pool

$14.82

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Product Cost from ABC

M o d e I M o d e I I M o d e I I ID i r e c t m a t e r i a l s 5 0 . 0 0$ 9 0 . 0 0$ 2 0 . 0 0$ D i r e c t l a b o r 6 0 . 0 0 8 0 . 0 0 4 0 . 0 0 M a c h i n e r yS e t u pE n g i n e e r i n gF a c i l i t i e sO t h e rT o t a l

These are the new product costs when Aerotech uses ABC.

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Product Cost from ABC

Mode I Mode II Mode IIIDirect materials 50.00$ 90.00$ 20.00$ Direct labor 60.00 80.00 40.00 Machinery 28.20 35.25 56.40 Setup 0.02 0.04 0.50 Engineering 17.50 15.75 52.50 Facilities 12.90 17.20 8.60 Other 14.82 23.57 212.85 Total 183.44$ 261.81$ 390.85$

These are the new product costs when Aerotech uses ABC.

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Distorted Product CostsBoth original and ABC target selling prices are

based on (Cost × 125%).

M o d e I M o d e I I M o d e I I I T o t a lT r a d i t i o n a l c o s t i n g209 .00$ 302 .00$ 126 .00$ A B C c o s t i n g 183 .44 261 .81 390 .85 u n i t s 10 ,000 20 ,000 4 ,000

T o t a l c o s t sT r a d i t i o n a l A B C

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Distorted Product CostsBoth original and ABC target selling prices are

based on (Cost × 125%).

M o d e I M o d e I I M o d e I I I T o t a l

T r a d i t i o n a l c o s t i n g2 0 9 .0 0$ 3 0 2 .0 0$ 1 2 6 .0 0$ N A

A B C c o s t i n g 1 8 3 .4 4 2 6 1 .8 1 3 9 0 .8 5 n a

u n i t s 1 0 ,0 0 0 2 0 ,0 0 0 4 ,0 0 0 n a

T o t a l c o s t s

T r a d i t i o n a l 2 ,0 9 0 ,0 0 0 6 ,0 4 0 ,0 0 0 5 0 4 ,0 0 0 8 6 3 4 0 0 0

A B C 1 8 3 4 4 0 0 5 2 3 6 2 0 0 1 5 6 3 4 0 0 8 6 3 4 0 0 0

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Distorted Product CostsBoth original and ABC target selling prices are

based on (Cost × 125%).

M o d e I M o d e I I M o d e I I IT r a d i t i o n a l c o s t i n g 209 .00$ 302 .00$ 126 .00$ A B C c o s t i n g 183 .44 261 .81 390 .85

O r i g i n a l t a r ge t s e l l i n g p r i c eA B C t a r ge t s e l l i n g p r i c e

.

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Distorted Product CostsBoth original and ABC target selling prices are

based on (Cost × 125%).

Mode I Mode II Mode IIITraditional costing 209.00$ 302.00$ 126.00$ ABC costing 183.44 261.81 390.85

Original target selling price 261.25 377.50 157.50 ABC target selling price 229.30 327.26 488.56

[$209.00 × 1.25] [$183.44 × 1.25]

The selling price of Mode I and II are reducedand the selling price for Mode III is increased.

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Can you identify any problems Aerotech is likely to face as a result of this distortion?

Mode I Mode II Mode IIITraditional costing 209.00$ 302.00$ 126.00$ ABC costing 183.44 261.81 390.85 Cost distortion per unit 25.56 40.19 (264.85) Units produced 10,000 20,000 4,000 Total cost distortion 255,600 803,800 (1,059,400)

Traditional costing understates the costof complex, low volume products.

Distorted Product Costs

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Indicators of Need for ABC

Line managers do notbelieve the product

costs reports

Marketing does notuse costs reports for

pricing decisions

Product-line profitmargins are hard

to explain

Sales are increasing,but profits are declining.

Some products thathave reported high

profit margins are notsold by competitors

Direct labor is asmall percentage

of total costs

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Activity-Based Management

The use ofABC costing information

to helpmanagement

make decisions

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Activity-Based Management

Activity-based costing establishes relationshipsbetween overhead costs and activities so that

we can better allocate overhead costs.

Activity-based management focuses on managing activities to reduce costs.

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Two-Dimensional ABC and Activity-Based Management

Activities

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Two-Dimensional ABC and Activity-Based Management

Cost Objects

Activities

Resource costs

Cost Assignment View

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Two-Dimensional ABC and Activity-Based Management

ActivityTriggers

Cost Objects

Activities

RootCauses

Process ViewActivity Analysis

Resource costs

Cost Assignment View

PerformanceMeasures

Activity Evaluation

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Elimination of Non-Value-Added Costs

Nonvalue-added

activities

NecessaryUnnecessary

Activities

Reduce orEliminate

Continually Evaluate

and Improve

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Using ABM to Eliminate Non-Value-Added Activities and Costs

1. Identify Activities.

2. Identify Non-Value-Added Activities.

3. Understand Activity Linkages, Root Causes, and Triggers.

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

Specifyparts

Selectvendor

Receiveparts

Producegoods

Inspectfinishedgoods

Reworkdefectiveproducts

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Using ABM to Eliminate Non-Value-Added Activities and Costs

Inspection time

Process time

Storage time

Move time Waiting time

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Customer Profitability Analysis

Customer profitability analysis usesactivity-based costing to determine

the activities, costs, and profit associated with serving particular customers.

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Customer Profitability Analysis

Orderssmall

quantities.

Ordersfrequently.

Oftenchangesorders.

Requiredspecial

packaging.

Demandfast

service.

A costly customer

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Customer Profitability Analysis

Customer-Related Activities Cost Driver Base Cost Drive

Rate Order processing Purchase orders 150$ Sales contacts (phone calls, faxes, etc.) Contacts 100 Sales visits Visits 1,000 Shipment processing Shipments 200 Billing and collection Invoices 160 Design/engineering change orders Design changes 4,000 Special packaging Units packaged 40 Special handling Units handled 60

A company may use these customerrelated costs to help determine the

profitability of each customer.

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Just-in-Time Inventory and Production Management

No materials are purchased and no products are manufactured until they are needed.

The primary goal of aJIT production system is

to reduce or eliminateinventories at everystage of production.

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Key Features of the JIT Approach

Smooth, uniform production rate

Pull method of production

Purchase is small lot sizes

Quick, inexpensive setups

High quality materials

Effective preventive maintenance

Teamwork

Multiskilled workers

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JIT Purchasing

Long-termcontracts with

suppliers.

Only a fewsuppliers.

Parts deliveredin small lots.

Minimalinspection of

materials.

Groupedpayments to

vendor.

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• Activity based costing in service industry• As useful as in mfg. industry• Mangers want more detailed and accurate

information about the cost of producing products and services they are selling

• Airlines, ins co, banks, hospitals, fin service firms, hotels railroads,

• Air France, American express, Bank of America, DHL, Fed Ex, US postal service

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ABC at service companies:

Identifying

Activities Activity cost pools Cost drivers

Classification of activities at • Unit level : • batch level, • product sustaining level, • facility (general operations) level

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Bajaj Allianze General Insurance Co. LtdClaims Department Classification of activities at • Unit level : Entering initial claim into computer• batch level: moving a batch of claims from one

processing step to the next• product sustaining level: maintenance of the

medical service provider network ( physicians, hospitals )

• facility (general operations) level: general administration of claims business unit

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• ABC at Delaware medical centre (Primary Care Unit- OPD)

• Patient Appointment • New routine extended complex• Continuing routine extended complex• Every appointment needs• Regd. nurse 1 : vital signs/preparing patient for

Primary health care professional• PHCP 1: physician / intern / resident doctor or

nurse practitioner

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• ABC team identified : • Activities cost drivers

Physician time Physician minutes with patient

Practitioner nurse time P-Nurse minutes with patient

Intern or resident time Intern minutes with patient

Regd. Nurse time Regd. Nurse minutes with patient

Clerical time: new patients New patient visits

Clerical time : continuing Continuiing patient visits

Billing Billing lines (items on a bill)

Facility Patient visits (both new and continuing)

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• Activity : physician time• Cost driver : physician minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 960000 240000 4 R 80000 320000 8000 $40• E 100000 400000 5000 $80• C 60000 240000 2000 $120

• Activity Nurse Practitioner time• Cost driver : NP minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 90000 30000 3 R 12000 36000 1200 $30• E 10000 30000 500 $60• C 8000 24000 320 $75

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• Activity : intern or resident time• Cost driver : intern or resident minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 412500 125000 3.30 R 40000 132000 4000 $33• E 50000 165000 2500 $66• C 35000 115500 1000 $115

• Activity : Rgd. nurse time• Cost driver : RN minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 281980 245200 1.15 R 132000 151800 13200 $11.50• E 80000 92000 8000 $11.50• C 33200 38180 3320 $11.50

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• Activity : Clerical time –new patients • Cost driver : New patients number• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 135300 12300 11.00 R 7200 79200 7200 $11• E 3000 33000 3000 $11• C 2100 23100 2100 $11

• Activity : Cleical time – continuing patients • Cost driver : cont. patients number• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 61100 12220 5.00 R 6000 30000 6000 $5• E 5000 25000 5000 $5• C 1220 6100 1220 $5

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• Activity : Billing • Cost driver : Billing lines on a bill• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 38480 76960 0.50 R 26400 13200 13200 $1.00• E 24000 12000 8000 $1.50• C 26560 13280 3320 $4.00

• Activity : Facility• Cost driver : number of new plus cont. patients visits • Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 245200 24520 10.00 R 13200 132000 13200 $10• E 8000 80000 8000 $10• C 3320 33200 3320 $10

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• Costing of service• 1. Each patient sees either a physician or PN or

intern or resident – not all four • 2. each patient is either a new patient or a

continuing patient and not both. • 3. to compute cost of particular appointment, we

should select only one of primary health care professionals, and select one of the two clerical time categories –new or continuing.

• 4. finally since every appointment involves RN , billing, and use of primary care unit facility, all of these activities must be included in the cost calculation.

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• Cost of extended appointment for a new patient seeing a nurse practitioner

• Activity Cost • Nurse practitioner time • RN time• Clerical time –new patients• Billing• Facility• Total 94.00

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• Cost of extended appointment for a new patient seeing a nurse practitioner

• Activity cost • Nurse practitioner time 60.00• RN time 11.50 • Clerical time –new patients 11.00• Billing 1.50 • Facility 10.00

• Total 94.00

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