Activity based costing

By

Prof. Augustin Amaladas

Meaning

• Activity-based costing (ABC), a strategy that gives you insight into the true cost of individual financial activities.

• . Break down your cost management process into transactions and then assign a value to each activity with our ABC solution: BusinessObjects™ Activity Analysis

• , Activity Analysis provides clear insight into customer, product, and channel profitability, and is a core component of enterprise performance management (EPM). The ability of Activity Analysis to accurately determine costs also aids in the costing and cross-charging of shared services like IT, HR, and finance.

Historical development• Traditionally cost accountants had arbitrarily added a broad

percentage of expenses onto the direct costs to allow for the indirect costs.

• However as the percentages of indirect or overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognised when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.

• The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Manufacturing-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.[1]

• Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products.

• Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs

• . Costs of the activities have been identified,• the cost of each activity is attributed to each

product to the extent that the product uses the activity.

• ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.

History

• [2] They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.

• Like manufacturing industries, financial institutions also have diverse products and customers which can cause cross-product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this

Methodology

• Cost center

• Cost allocation

• Fixed cost

• Variable cost

• Cost driver

• Direct labor and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions takes at the counter and then by measuring the number of each type of transaction.

• Limitations• Even in activity-based costing, some overhead

costs are difficult to assign to products and customers, for example 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

The Four Steps to ABC Implementation

1. Identify activities—perform an in-depth analysis of the operating processes of each responsibility segment. Each process may consist of one or more activities required by outputs.

• Assign resource costs to activities—this is sometimes called "tracing." Traceability refers to tracing costs to cost objects to determine why costs were incurred. DoD categorizes costs in three ways:

– Direct—costs that can be traced directly to one output. Example: the material costs (varnish, wood, paint) to build a chair.

– Indirect—costs that cannot be allocated to an individual output; in other words, they benefit two or more outputs, but not all outputs. Examples: maintenance costs for the saws that cut the wood, storage costs, other construction materials, and quality assurance.)

• General & Administrative—costs that cannot reasonably be associated with any particular product or service produced (overhead). These costs would remain the same no matter what output the activity produced. Examples: salaries of personnel in purchasing department, depreciation on equipment, and plant security.

• Identify outputs—identify all of the outputs for which an activity segment performs activities and consumes resources. Outputs can be products, services, or customers (persons or entities to whom a federal agency is required to provide goods or services

Assign activity costs to outputs—assign activity costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs’ consumption or demand for activities. For example, a driver may be the number of times an activity is performed (transaction driver) or the length of time an activity is performed (duration driver).

• Activity-Based Costing encourages managers to identify which activities are value-added—those that will best accomplish a mission, deliver a service, or meet a customer demand. It improves operational efficiency and enhances decision-making through better, more meaningful cost information.

Exercise 16(Activity Based costing)• A company produces four products P,Q,R and S. The data relating

to production activity are as under:

Product Qty.of production

Material cost/unit

Direct labour/unit

Machine hours/unit

Direct labour cost/unit

PQ

R

S

500

5,000

600

7000

5

5

16

17

1/2

1/2

2

1-1/5

0.50

0.50

1.00

1-1/5

3

3

12

9

Production overheads are as under:i) Overheads applicable to machine oriented activity-37,424

ii)Overhead relating to ordering materials-Rs.1920iii) Setup Costs-Rs.4355

iV) Administration overheads for spare parts: Rs.8600v) Materials handling costs-7580

• The following further information have been compiled:

Product No.of setup No. of materials

order

No.of times materials handled

No.of spareparts

PQR

S

1

6

2

8

1

4

1

4

2

10

3

12

2

5

1

4

Required:1) Select a suitable cost driver for each item of overhead expenses and calculate the cost per unit of cost driver

2.Using the concept of activity based costing , compute the factory cost per unitOf each product.

These overhead costs are observed by products on a machine hour rate of Rs.4.80 per hour having an overhead cost per product of:

A=Rs.1.20, B=Rs.1.20, C=4.8 D=Rs.7.2

Answer for 16

• Factory overhead applicable to machine oriented activity=Rs.37,424

• Total machine Hours=Volume *Machine hour required for each period= (500*1/4)+(5,000*1/4)+(600*1)+(7,000*1.5)=12,475 hrs.

• Machine overhead charged =37,424/12,475 hrs=Rs.3 per hour

• Set up costs=4355/17(ie., total number of set ups)=Rs.256.18

• Material ordering cost=1920/10 operations=Rs.192• Material handling cost=7580/27 operations=Rs.280.74• Spare parts=8600/12 parts=716.67

Answer-16….

Overhead items A B C D

Machine overhead

Setup cost

Material

Ordering cost

Material handling cost

Spare parts cost

¼*Rs.3=.0.75

1*256.18/500=0.51

1*192/500=

0.38

2*280.74/

500=1.12

2*716.67/500=

2.87

¼*3=0.75

6*256.18/

5000=0.31

4*192/5000=0.15

10*280.7/

5000=0.56

5*716.67/

5000=0.72

1*.3=Rs.3

2*256.18/

600=0.85

1*92/600=

0.32

3*280.74/

600=1.40

1*716.67/

600=1.19

3/2*3=4.5

8*256.18/7000=0.29

4*192/

7000=0.11

12*280.74/7000=0.48

4*716.67/

7000=0.41

products

Machine

overheads Material ordering

Material handling

Spare

Parts

Total

(ABC systems)

Total

(old system)

difference

A

B

C

D

0.75

0.75

3.00

4.50

0.38

0.15

0.32

0.11

1.12

0.56

1.40

0.48

2.87

0.72

1.19

0.41

5.63

2.49

6.76

5.79

1.20

1.20

4.80

7.20

+4.43

+1.29

+1.96

-1.41

traditional system does not make correct assumptions that all overheads are

Related to volume and machine time. Under traditional system products A and C are

under costed because it misallocates costs for small volume products.

Set upsRs.

0.510.310.850.29

Answer- Activity costing…• The activity based costing recognises the amount of input to each

cost unit.• Product B previously avoided its full share of overhead because of

its• low machine time and may still do so if part of Rs. 37,425 of

machine oriented • overhead should be apportioned on some other basis.• Product D is over costed because the additional system loaded it

with • Other attributable to activities concerned with products A,B and C as • result of using a volume –based and machine oriented rate which

failed to• Pay proper attention to activity costing.

Activity costing-Exercise-2• A Company manufactures several products of varying levels of

designs and models . It uses a single overhead recovery rate based on direct labour hours. The overheads incurred by the company in the first half of the year are as under.

• Machine operating expenses 10,12,500• Machine maintenance expenses 1,87,500• Salaries to technical staff 6,37,500• Wages and salaries of stores staff 2,62,500

• During the period, the company introduced activity based costing system and the following significant activities were identified:

• - receiving materials and components• - setup of machines for production runs• - Quality inspection.

• It is also determined that :• -The machine operation and machine maintenance expenses

should be apportioned between stores and production activity in 20:80 ratio.

• The technical staff salaries should be apportioned between machine maintenance, set up and quality inspection in 30:40:30 ratio.

• The consumption of activities during the period under review are as under:

• Direct labour hours worked 40,000• Direct wages rate Rs. 6 per hour 2040• Material and component consignments received from suppliers

1960• Number of quality inspections carried out 1280

• The data relating to two products manufactured by the company during the period are as under:

• Product P Product Q• Direct material costs Rs.6000 Rs.4000• Direct labour hours 960 100• Direct material consignment received 48 52• Production runs 36 24• Number of quality inspection done 30 10• Quantity produced 15,000 5,000

A potential customer has approached the company for the supply of 24,000 units of a component K to be delivered in lots of 3,000 units per quarter. The job will involve an initial design cost of Rs. 60,000 and the manufacture will involve the following per quarter.

Direct material cost - Rs.12,000; Direct labour hours - 300; Production runs- 6; Inspections- 24; Number of consignments of direct materials to be received -20

• The company desires to mark up of 20% on cost.• Required:• 1. Calculate the cost of products P and Q based on the existing

system of single overhead recovery rate.• 2. Determine the cost of products P and Q using activity based

costing system.• 3. Compute the sales value per quarter of component K using

activity based costing system.

Answer• Working notes:• 1. Overhead rate=21,00,000/4000 hours=Rs.52.50• 2. Apportionment of technical staff salaries:• Machine maintenance, Set up and Quality Inspection respectively

=6,37,500* 30:40:30/100• = 1,91,250; 255,000and 1,91,250.• 3. Rate per Cost driver:• Store receiving =275.89• Set-up production run = 670.59• Quality Inspection= 149.41• 4. Single overhead recovery rate : Cost per Unit P=4.144: Q=1.97• 5.Store receiving= 5,40,750:set-up production run=13,68,000• 6. Rate per activity 5,40,750/1960=275.89; 13,68,000/2040=670.59;

1,91,250/1280=149.41 for store receiving, setup and quality inspection respectively.

P and Q as per activity based costing system

Particulars P Q

Units

Direct materials cost

Direct labour cost

Receiving /sores cost(48*275.89)

(52*275.89)

Production runs/set up cost (36* 670.59)

(24*670.59)

Inspection cost (30* 149.41)

(10* 149.41)

Total cost of products

Cost per unit

15000

6000

5760

13243

24141

4482

53626

3.58

5000

4000

600

14346

16094

1494

36534

7.31

Computation of sales value per quarter of component K(Activitity based costing)

Particulars K

Units

Components of initial design(Rs.60000/8)

Direct materials cost

Direct labour cost (300 hours 8 Rs.6)

Receiving /sores cost(20*275.89))

Production runs/set up cost (6* 670.59)

Inspection cost (24* 149.41)

Total cost of products

Add: Mark up( 25% of cost)

Sales value

Selling price per unit of K(43035/3000 units)

3000

7500

12000

1800

5518

4024

3586

34428

8607

43035

14.34

Life cycle costing

• Life cycle cost analysis became popular in the 1960s when the concept was taken up by U.S. government agencies as an instrument to improve the cost effectiveness of equipment procurement. From that point, the concept has spread to the business sector, and is used there in new product development studies, project evaluations and management accounting.

Realization of a life cycle cost analysis

• A life cycle cost analysis calculates the cost of a system or product over its entire life span. This also involves the process of Product Life Cycle Management so that the life cycle profits are maximised.

"cradle-to-grave analysis", or "Womb-to-Tomb

• The analysis of a typical system could include costs for:• planning,• research and development,• production,• operation,• maintenance,• Cost of replacement,• disposal or salvage.• This cost analysis depends on values calculated from

other reliability analyses like failure rate, cost of spares, repair times, and component costs.

• A life cycle cost analysis is important for cost accounting purposes. In deciding to produce or purchase a product or service, a timetable of life cycle costs helps show what costs need to be allocated to a product so that an organization can recover its costs. If all costs can not be recovered, it would not be wise to produce the product or service.

• It offers three important benefits:- All costs associated with a project/product become visible, especially: upstream, R&D; downstream, customer service.- It allows an analysis of business function interrelationships. Low R&D costs may lead to high customer service costs in the future.

• - Differences in early stage expenditure are highlighted, enabling managers to develop accurate revenue predictions.

• A typical quantitative analysis would involve the use of a statement where an easy comparison of costs can be seen by having the different products a company produces next to each other.