abc cost accounting
DESCRIPTION
Cost Accounting basicsTRANSCRIPT
Activity-Based Costing (ABC)
and Cost Management Systems
A revolutionized system for a revolutionized Environment
Cost and Cost Terminology
CostAccumulation
Cost Object
Cost Object
Cost Object
CostAssignment
Tracing
Allocating
Cost and Cost Terminology
Traditional Costing Systems
Overhead cannot be traced easily and must be assigned with estimates
Direct materials and direct labor costs are easy to trace
Spreads overhead cost over entire product base
Products with high profit margins subsidize orders with low profit margins
A single or plantwide rate called POHR used
Direct tracingDriver tracingAllocation
Indicators of Need for ABCIndicators of Need for ABC
Line managers do notbelieve the product
costs reports
Line managers do notbelieve the product
costs reports
Marketing does notuse costs reports for
pricing decisions
Marketing does notuse costs reports for
pricing decisions
Product-line profitmargins are hard
to explain
Product-line profitmargins are hard
to explain
Sales are increasing,but profits are declining.
Sales are increasing,but profits are declining.
Some products thathave reported high
profit margins are notsold by competitors
Some products thathave reported high
profit margins are notsold by competitors
Direct labor is asmall percentage
of total costs
Direct labor is asmall percentage
of total costs
Total overhead from depreciation on equipment, utilities, repairs, maintenance has increased
Total overhead from depreciation on equipment, utilities, repairs, maintenance has increased
Each product line can consume different ratios of overhead costs
Each product line can consume different ratios of overhead costs
Activity-Based Costing (ABC) An overhead cost allocation system that
allocates overhead to multiple activity cost pools and assigns the activity cost pools to products or services by means of cost drivers that represent the activities used.
Activity based costing allocates costs based on the discreet tasks (activities) that drive those costs.
Activity based costing allocates costs based on the discreet tasks (activities) that drive those costs.
Reasoning for ABC
ASSUMES • COSTS GENERATED BY ACTIVITES PERFORMED BY ORGANISATION
• EACH ACTIVITY CARRIED OUT BY ORGANISATION IS THE PROCESS
Activity-Based Costing (ABC)
Calculate unit cost
Identify, define, classify activities
Identify cost driver
Compute cost of activities
Compute overhead rate
Assign overhead costs to products
Step 1: Identify ActivityAny event, action, transaction, or work sequence that causes a
cost to be incurred in producing a product or providing a service.
TOP DOWN APPROACHTOP DOWN APPROACHABC teams of middle-management or above
develop the activity dictionary.
TOP DOWN APPROACHTOP DOWN APPROACHABC teams of middle-management or above
develop the activity dictionary.
RECYCLING RECYCLING APPROACHAPPROACH
Reuses documentation of
processes used for other purposes.
RECYCLING RECYCLING APPROACHAPPROACH
Reuses documentation of
processes used for other purposes. INTERVIEW OR INTERVIEW OR
PARTICIPATIVE PARTICIPATIVE APPROACHAPPROACH
ABC teams include or interview operating
employees.
INTERVIEW OR INTERVIEW OR PARTICIPATIVE PARTICIPATIVE
APPROACHAPPROACHABC teams include
or interview operating
employees.
Step 1- Classify Activities into Activity Cost Pool
The overhead cost allocated to a distinct type of activity or related activities.
FabricationFabricationcost cost poolpool
Assembly Assembly Cost poolCost pool
SetupSetupcost poolcost pool
EngineeringEngineeringcost cost poolpool
Quality Quality ControlControl
cost poolcost pool
UnitLevel
BatchLevel
Product-Sustaining Level Facility Level
Activitymust bedone oneach unitproduced.
Activityperformedon eachbatch
produced.
Activities Activities needed to needed to
supportsupportan entire an entire product product
lineline
Activity required in
orderfor the
productionprocess to occur.
Identificationof ActivityCost Pools
Identificationof ActivityCost Pools
Step 2 Identify Activity Cost DriverCost Drivers – a characteristic of an activity or event that
results in the incurrence of costs.
In ABC cost drivers are used to assign activity cost pools to products or services.
Have a cause-effect relationship with the activityand the use of resources (costs).
Have a cause-effect relationship with the activityand the use of resources (costs).
Be feasible to measureBe feasible to measure
Predict or explain activities’ use of resources (cost) with reasonable accuracy
Predict or explain activities’ use of resources (cost) with reasonable accuracy
Be based on the practical capacity of the resources to support activities
Be based on the practical capacity of the resources to support activities
Step 2 Identify Activity Cost Driver
Some Examples of Activity Cost Pools and Cost Drivers:
Activity Cost Pools Cost Driver
Material purchasing No. of purchase orders
Material handling No. of parts
Production scheduling No. of batches
Quality inspections No. of inspections
Photocopying No. of pages
Warranty service No. of service calls
Activities and Related Cost Drivers
Illustration 4-3
Step 3 Compute Cost of ActivitiesWhen estimating the cost
of an activity, only the costs associated with the product should be used (practical capacity). The
cost of “unused capacity” should not be
applied to products.
When estimating the cost of an activity, only the
costs associated with the product should be used (practical capacity). The
cost of “unused capacity” should not be
applied to products.
EXAMPLE
Suppose we rent a 1,000 square foot warehouse for $1,000 per
month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”.
How much rent cost should be allocated to Product A?
EXAMPLE
Suppose we rent a 1,000 square foot warehouse for $1,000 per
month. Only 800 sq. ft. are used to store Product A. The rest of the warehouse is “unused”.
How much rent cost should be allocated to Product A?
20%, or $200 should be assigned to
“unused capacity”
80%, or $800 should be assigned
to Product A
Step 4 Compute Overhead Rate
EXAMPLE #1EXAMPLE #1XCo has 4 employees in its Quality Control Dept. Salaries and costs for the department total $360,000 per year. XCo produces 500,000
units of product a year. What is the appropriate activity, # of
employees or units of product? What is the cost-driver rate?
EXAMPLE #1EXAMPLE #1XCo has 4 employees in its Quality Control Dept. Salaries and costs for the department total $360,000 per year. XCo produces 500,000
units of product a year. What is the appropriate activity, # of
employees or units of product? What is the cost-driver rate?
EXAMPLE #1EXAMPLE #1The proper activity in this case is the # of units produced.
The cost-driver rate would be:$360,000 ÷500,000 units = $.72 per unit
EXAMPLE #1EXAMPLE #1The proper activity in this case is the # of units produced.
The cost-driver rate would be:$360,000 ÷500,000 units = $.72 per unit
Two pieces of information are required
to compute the cost-driver rate:
•Activity Cost
•Activity Volume
Two pieces of information are required
to compute the cost-driver rate:
•Activity Cost
•Activity Volume
Step 5 Assign Overhead Cost to Products
1. Identify all the activities related to a
given product or service.
1. Identify all the activities related to a
given product or service.
2. Determine how many
units of each activity are
used per unit of product.
2. Determine how many
units of each activity are
used per unit of product.
3. Assign costs to products
using the cost-driver rates for each activity
3. Assign costs to products
using the cost-driver rates for each activity
Traditional Costing vs ABC
Activity Cost Pools
Activity
Cost Drivers
When Should a Company Use ABC?
ABC is often considered as an option when one or more of the following conditions exist:
Multiple products produced
Indirect costs are significant in proportion to direct costs and use only one or two cost-drivers.
Goods are complex, requiring many inputs and processes.
Simple, high-volume products perform more poorly than complex, low-volume products.
Different departments believe costs are assigned inaccurately.
The company loses bids it thought were low, and wins bids it thought were high.
Operations have changed significantly, but the costing system has not changed.
Product Variety Creates Overhead Costs
Approximately Relevant ABC Systems Use only the most expensive activities for ABC
assignment. These costs are assigned using cause-and-effect drivers.
All other activity costs are added to cost pools of the expensive activities and assigned arbitrarily.
What About Small Activities in ABC?
Why Companies Use ABC
Chemtech produces hundreds of different chemicals.
AMONG ALL FOLLOWING CHEMICALS ARE MORE POPULAR
Aldehyde (a commodity chemical used by producing plastics) and…
Phenylephrine Hydrochloride (PH), which is a specialty chemical for manufacturing blood-pressure medications.
In the past, Chemtech’s manufacturing department has used a single indirect cost pool.
It has used direct labor hours as its single allocation base at a 200% rate.
Traditional Costing vs ABC
Chemtech Traditional Cost System Aldehyde PH
Sales price per pound $10 $70
less manufacturingcost per pound:
Direct materials 5 20
Direct labor 1 10
Manufacturing overhead 2 20 Gross margin per pound $ 2 $20
Traditional Costing vs ABC
Under the traditional costing approach gross margin for PH is 10 times as high as the gross margin for the aldehyde.
Assume that the company produced 7,000 pounds of aldehyde and 5 pounds of PH.
Traditional Costing vs ABC
•What is the total labor cost assigned to each product?
•aldehyde --7,000 pounds x $1 = $7,000•PH--- 5 pounds x $10 = $50
•Chemtech assigns to aldehyde 140 times as much direct labor as it does to PH.
$7,000/$50 = 140
What is total manufacturing overhead allocated to each?
Aldehyde--- $7,000 x 200% = $14,000
PH-- $50 x 200% = $100
Chemtech assigns 140 times as much overhead to aldehyde as to PH.
1 Identify the activities PERFORMED
Three specific activities were identified in the chemical manufacturing department:
– Mixing, Processing, Testing
Activity Based Costing
2 Estimate the total indirect costs of performing each activity.
It was estimated that total mixing costs for all products will be $600,000.
Labor $150,000 Depreciation 200,000 Other 250,000 Total
$600,000
Depreciation
Ca I
3 Similarly, identify the primary cost driver for each activity’s indirect costs.
(1) (2) (3) Activity Estimated Costs Cost Driver Mixing $600,000 # of batches Processing $300,000 # of machine hours (MH) Testing $600,000# samples
Activity Based Costing
Workers mix ingredients separately for each batch of chemicals, so the number of batches drives mixing costs.
Activity Based Costing
4 Estimate the total quantity of each allocation base.
It was estimated that the mixing department will produce 4,000 batches of chemicals.
(1) (4) Activity Estimated Quantity
of Cost Driver Mixing 4,000 batches Processing 5,000 machine hours Testing 3,000 samples
5 Compute the allocation rate for each activity.
The estimated cost for each activity is divided by the estimated quantity of the cost driver to obtain a cost allocation rate.
5 Allocation rate = Estimated indirect costs of activity/Estimated quantity of allocation base
Activity Based Costing
(1) (5) Activity Cost Allocation Rate Mixing $600,000/4,000 = $150/batch Processing $300,000/5,000 = $60/MH Testing $600,000/3,000 = $200/sample
6 Obtain the actual quantity of each allocation base used by each product.
SUPPOSE, during the year, Chemtech produced 60 batches of aldehyde and 1 batch of PH.
The remaining batches consist of Chemtech’s other chemicals.
Activity Based Costing
7 Allocate the costs to each product.
Mixing costs are allocated as follows:
– Aldehyde: 60 batches x $150 per batch = $9,000
– PH: 1 batch x $150 per batch = $150
Activity Based Costing
Activity Cost Driver Units Cost Allocated to: Used By:
Aldehyde PH Aldehyde PH
Mixing 60 batches 1 batch $ 9,000 $150
Processing 301/2 MH 2 MH 1,830* 120
Testing 14 samples 1 sample 2,800 200
Total $13,630 $470
*301/2 MH x $60 per MH = $1,830
The ABC system allocates 29 times as much overhead to aldehyde as to PH ($13,630/$470 = 29).
This is much less than the cost allocated to aldehyde in the original direct-labor-based system, which allocated 140 times as much overhead to aldehyde as to PH.
Activity Based Costing
•What is the total labor cost assigned to each product?
•aldehyde --7,000 pounds x $1 = $7,000•PH--- 5 pounds x $10 = $50
•Chemtech assigns to aldehyde 140 times as much direct labor as it does to PH.
$7,000/$50 = 140
What is the overhead cost per pound?
Remember that 7,000 pounds of aldehyde were produced and 5 pounds of PH.
Aldehyde $13,630/7,000 = $1.95
PH $470/5 = $94
Activity Based Costing
Comparison of overhead cost per pound under the traditional system with the ABC costs:
Overhead Traditional direct ABC
labor system system Aldehyde $ 2.00 $ 1.95
PH $20.00 $94.00
Chemtech Traditional Cost System Aldehyde PH
Sales price per pound $10$70 less manufacturingcost per pound: Direct materials 520 Direct labor 110 Manufacturing overhead 220 Gross margin per pound $ 2$20
Chemtech Gross Margin per Pound
Aldehyde PH Sales price per pound $10.00 $70.00 less manufacturing
cost per pound:
Direct materials 5.00 20.00
Direct labor 1.00 10.00
Manufacturing overhead 1.95 94.00
Gross margin per pound $2.05 $(54.00)
Activity Based Costing
124
USING ABC COSTS TO MAKE BUSINESS DECISIONS.
Activity Based Costing
Two main benefits of ABC are...
1 more accurate product cost information.
2 more detailed information on costs of activities and the drivers of those costs.
These benefits help managers make better decisions about cost control and the sales prices to charge for their products.
ABC system shows that Chemtech’s manufacturing cost for PH is $124, rather than the $50 reported by the traditional system.
Chemtech was losing $54 on every pound of PH - and this is before considering non-manufacturing costs such as R&D, marketing and distribution.
Chemtech’s PH Cost Comparision
PH (ABC) PH (Traditional)
Sales price per pound $70 $70
less manufacturing cost per pound: Direct materials 20 20 Direct labor
10 10 Manufacturing overhead 94 20 Gross margin per pound $ (54) $20
Activity Based Costing
Chemtech has three alternatives:
1 Cut the cost of PH.
2 Increase the sale price of PH.
3 Drop the PH product.
Activity Based Costing
Benefits of Activity-Based CostingMore accurate product costing which necessitates:
More cost pools used to assign overhead
Enhanced control over overhead
Better management decisions
Limitations of Activity-Based Costing
Can be expensive to use.
Some arbitrary allocations continue.
Switch to ABC when... Products differ greatly in volume and
manufacturing complexity Products lines are
numerousdiverse require differing degrees of support
services Overhead costs constitute a significant portion
of total costs The manufacturing process or number of
products has changed significantly Production or marketing managers are
ignoring data provided existing system
DECIDE WHEN ABC IS MOST LIKELY TO PASS THE COST-BENEFIT TEST.
Activity Based Costing
ABC’s benefits are higher when...
– the company produces many different products that use different amounts of resources.
– the company has high overhead costs.
– the company produces high volumes of some products, and low volume of other products.
DECIDE WHEN ABC IS MOST LIKELY TO PASS THE COST-BENEFIT TEST.
Activity Based Costing
The costs of adopting ABC are lower when the company has...
– accounting and information system expertise to develop the system.
– information technology (bar coding, optical scanning) to record cost driver data.
Activity Based Management
Activity Based Management (ABM) – uses an activity based costing system to improve the operations of an organization.
Keep in mind !
ABC and ABM are being applied in both Manufacturing and Service Industries!!!
ACTIVITY BASED COSTING
SETUPDEPTT
ADMINISTERPARTS
SUPPORTDIRECTLABOUR
SETUPMACHINES
PRODUCT 1 PRODUCT 2 PRODUCT 3
RAWMATERIALINVENTORYDEPTT
MFCTGENGINRGDEPTT
Stage 1Determinewhat activitiesare performedby company resources
Stage 2Attributecosts toproductsbased on their use ofresources
Other***indirect resources
Other***activities
Other***products
Two Stage Assignment Process: Activity Based Costing
ACTIVITY BASED COSTING
WHICH CUSTOMERS ARE PROFITABLE & WHY?IDENTIFY THE TRUE COSTOF CUSTOMERS OR TYPES
OF CUSTOMERS
WHICH PRODUCTS SHOULD WE PROMOTE?
ANALYSE PROFIT CONTRIBUTION &IMPACT OF INTER-RELATIONSHIPS OF
PRODUCT/SERVICES
WHICH PRICES SHOULDWE SET?
IDENTIFY THE TRUE COST/PROFITABLY OF
PRODUCTS/SERVICES
HOW SHOULD WE MEASURE PERFORMANCE?IDENTIFY ACCOUNTABILITY
RESPONSIBILITY FORCOST BEHAVIOUR
GAINING COMPETITIVE ADVANTAGE THROUGH ABC
WHICH DISTRIBUTIONCHANNEL SHOULD WE USE?
ANALYSE THE COST &PERFORMANCE OF
ALTERNATIVE DISTRIBUTIONCHANNELS
GAININGCOMPETITIVEADVANTAGE