Activity-Based Costing
BETTER COSTING FOR BETTER DECISIONS
Learning Objectives
Distinguish between the traditional and the activity-based costing approaches.
Evaluate the costs and benefits of implementing activity-based costing systems.
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 to managers and operators about process efficiency.
INDIRECT COSTS
Not easily and conveniently traceable to cost objects
Cost
element is shared among cost objects Physically impossible to trace Not cost effective to trace
INDIRECT COSTS
Need for allocation
Estimate
What
product or activity cost
awareness of indirect costs
are not free
does it really cost?
Increase
Activities
Plan
more cost efficient operations
that we know what it costs, what should we
Now
do?
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 400,000 total labor hours = $25 per hour rate
A product consuming 6 labor hours would be charged $150 of indirect costs
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
Costs Products
Activity-based allocation method
Costs
First stage
Activities
Products
Second stage
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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
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OVERVIEW OF ABC
Identifies activities required to produce the product or service Determines the cost of the activities Allocates costs to the cost object based on the objects consumption of activities
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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
The primary objective of ABC is to assign costs that reflect/mirror the physical dynamics of the business
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Basics of A B C (contd.)
Provides ways of assigning the costs of indirect support resources to activities, business processes, customers, products. It recognises that many organisational resources are required not for physical production 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 drivers 5. Calculate cost
Cost pools are groups or categories of individual expense items
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IMPLICATIONS OF ABC/ABM
Shifts focus from managing costs to managing activities Aids in recognizing, measuring and controlling complexity Promotes understanding of why costs are incurred Provides better cost allocation information
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IMPLICATIONS OF ABC/ABM
Useful for planning future operations Fosters continuous improvement Likely to meet with substantial resistance
Analysis
of why and how activities are performed
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Existing Single IndirectCost Pool System Example
Kole Corporation manufactures a normal lens (NL) and a complex lens (CL). Kole currently uses a single indirect-cost rate job costing system. Cost objects: 80,000 (NL) and 20,000 (CL).
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Direct Material
Direct Manuf. Labour No. of Units Manuf. Labor Hrs Selling Price
NL 1,520,000 800,000 80,000 36,000
CL 920,000 260,000 20,000 14000
60
142
How much indirect costs are allocated to each product and what is profit margin? Total indirect Cost is 2900,000 which is to be allocated on the basis of direct manufacturing Labour Hrs used.
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Existing Single IndirectCost Pool System Example
Normal Lenses (NL) Direct materials Direct mfg. labor Total direct costs $1,520,000 800,000 2,320,000
Direct cost per unit: $2,320,000 80,000 = $29
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Existing Single IndirectCost Pool System Example
Complex Lenses (CL) Direct materials $ 920,000 Direct mfg. labor 260,000 Total direct costs $1,180,000 Direct cost per unit: $1,180,000 20,000 = $59
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Existing Single IndirectCost Pool System Example
INDIRECT-COST POLL
All Indirect Costs $2,900,000
INDIRECT COST-ALLOCATION BASE
50,000 Direct Manufacturing Labor-Hours
$58 per Direct Manufacturing Labor-Hour
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Existing Single IndirectCost Pool System Example
COST OBJECT: NL AND CL LENSES Indirect Costs Direct Costs
DIRECT COSTS
Direct Materials
Direct Manufacturing Labor
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Existing Single IndirectCost Pool System Example
NL: 36,000 $58 = $2,088,000 CL: 14,000 $58 = $812,000 What is the total cost of normal lenses? Direct costs $2,320,000 + Allocated costs $2,088,000 = $4,408,000
What is the cost per unit?
$4,408,000 80,000 = $55.10
Existing Single IndirectCost Pool System Example
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
Existing Single IndirectCost Pool System Example
Normal lenses sell for $60 each and complex lenses for $142 each. Normal Complex $60.00 $142.00 55.10 99.60 $ 4.90 $ 42.40 8.2% 29.9%
Revenue Cost Income Margin
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ABC COSTING
Activity identified: 1. Design of Products and Process 2. Setup & Manufacturing Operations 3. Shipping and Distribution
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Refining a Costing System
1. Design of Products and Process The Design Department designs the molds and 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 and sent to the various customers.
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Activity-Based Costing System
Activity Indirect Cost Pool Design Setup Shipping
Cost Allocation Base
PartsSquare feet
No. of Setup Hours
No. of Shipments
Product Cost Objects
Lenses NL
Lenses CL
Lenses Other
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Activity-Based Costing System
Consumption of Indirect Cost $2900000 as per activity. Activities Total cost base Design feet $1800000 Cost allocation 100 Parts square
Set up
$409,200
2640 Setup-hours
200 Shipments
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Shipment $690800
Activity-Based Costing System
Calculate cost of production per unit as per ABC from given information. NL Quantity produced No. of unit/batch 80,000 250 CL Total
20,000 100000 50
Number of batches
Setup time per batch Total setup-hours Total parts sq. ft. used Total no. of Shipments
320
2 hrs 640 30 100
400
5 hrs 2,000 70 100
720
2640 100 200
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Activity-Based Costing System
What is the design cost per square feet?
$1800000 100 Sq. Ft = $18000
What is the setup cost per setup-hour?
$409,200 2,640 hours = $155
Activity-Based Costing System
What is the shipping cost per shipment? $690800 200 = $3454
Allocation of cost for design department using parts square feet : NL: $18000 30 = $ 540000 CL: $18000 70 = $1260000 Total $1800000
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Output Unit-Level Costs
Allocation of cost for set up department using setup-hours: NL: $155 640 = $ 99,200 CL: $155 2,000 = $310,000 Total $409,200 Allocation of cost for shipping department using no. of shipment: NL: $3454 100 = $ 345400 CL: $3454 100 = $ 345400 Total $690800
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Product-Sustaining Costs
Total cost of NL Prime cost$2,320,000 Design department- $540000 Set up department$99200 Shipping department-$345400 Total cost- $3304600
Total cost- $3304600 Unit cost of NL is $41.31
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Facility-Sustaining Costs
Total cost of CL Prime cost$1,180,000 Design department- $1260000 Set up department- $310,000 Shipping department-$345400 Total cost- $3095400 Unit cost of CL is $154.77
Profit from NL=$18.69 Profit from CL=-$12.77 Profit margin= 31.15% Profit margin= -8.99%
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Benefits of ABC Systems
Significant amounts of indirect costs are allocated using only one or two cost pools. All or most costs are identified as output unit-level costs. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.
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Benefits of ABC Systems
Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.
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Limitations of ABC Systems
The main limitations of ABC are the measurements necessary to implement the system.
ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.
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Learnings
Distinguish between the traditional and the activity-based costing approaches.
Evaluate the costs and benefits of implementing activity-based costing systems.
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Any Question Thanx
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