activity based costing
DESCRIPTION
Activity Based CostingTRANSCRIPT
ACTIVITY BASED COSTING
Presented By:- Ramanjeet Singh
Jayesh Varun
Vipin Kumar
Ashirdeep Singh
Harsh Kumar
Rahul mattoo
Requirement of Cost Systems• Valuation of the cost of goods sold for financial
reporting.
• Estimation of the costs of activities, products,
services.• Providing economic feedback to managers
and operators about process efficiency.
Today’s businesses are working in an increasingly complex environment.
Use of Advanced Technology
Product Life Cycle
Product Complexity
Channels of Distribution
Quality Requirements
Product Diversity
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.
ACTIVITY BASED COSTING
Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each.
This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.
Conventional Costing
Expenses
Cost Objects
AB Costing
Resources
Activities
Cost Objects
Economic Element
Work Performed
Product or service
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
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
ABC SYSTEMS ADDRESSES THE FOLLOWING QUESTIONS:
What activities are being performed by the organisational resources?
How much does it cost to perform activities?
Why does the oranisation need to perform those activities?
How much of each activity is required for the organisation’s products, services, and customers?
TERMINOLOGIES…. Overheads: Overhead is those costs
required to run a business, but which cannot be directly attributed to any specific business activity, product, or service.
Examples of overhead are: Accounting and legal expenses Administrative salaries Depreciation Insurance Licenses and government fees Property taxes Rent Utilities
Cost Pools: Costs in any one cost pool are attributed using the same cost driver. A cost pool may relate to an activity, or a Support cost:Activity cost pools represent the costs of
activities. There are three main activity cost pools – one for each of Teaching, Research, and Other. Additional cost pools are needed for sub-activities.
Support cost pools are intermediate holding places. The costs of a finance department may be separated into a number of cost pools – relating to payroll, fees, all other areas. A different cost driver is used for each cost pool (staff time/numbers, all other costs) when attributing its costs to an activity cost pool.
Cost Drivers: An activity which generates cost.
A factor such as level of activity or volume that casually affects cost.
Existence of a cause-and-effect relationship between a change in the level of activity or volume and change in the level of total costs of that cost object.
Thus cost drivers signify factors, forces or events that determine the costs of activities
NEED OF ACTIVITY BASED COSTING….
Manufacturing overhead costs have increased significantly.
The manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours.
The diversity of products and the diversity in customers' demands have grown.
Some products are produced in large batches, while others are produced in small batches.
Problem of over-costing and under-costing.
OVER COSTING & UNDER COSTING
Over costing:- A product consumes a relatively low level of resources but is reported to have a relatively high total cost.
Under costing : A product consumes a relatively high level of resources but is reported to have a relatively low total cost.
UNDER COSTING AND OVER COSTING EXAMPLE:-
Ram, Saquib, and harshit order separate items for lunch which costs:-
Ram’s order amounts to Rs. 14 Saquib’s order amounts to Rs. 30 Harshit’s order amounts to Rs. 16 Total: Rs. 60What is average cost per lunch? 60/3 =20
Ram And Harshit over
costed.
Saquib under costed
NUMERICAL…..
Super manufacturer produces 2 types of products
1. Complex lenses (CL) 2. Simple lenses(SL)
Production:CL 20000NL 80000
Manufacturing labor hours = 50000
DIRECT COST
NL Direct Material = 1520000Direct labor = 800000Total direct cost = 2320000Direct cost per unit = 2320000/80000 = 29 CL Direct Material = 920000Direct labor = 260000Total direct cost = 1180000Direct cost per unit = 1180000/20000 = 59
INDIRECT COST TOTAL 2900000
Conventional method
Cost/labor hourCost 2900000/50000=Rs.58Super uses 36000 manufacturing labor-hours to male NL and 14000 direct manufacturing labor-hours to make CL
CL 14000*58= 812000NL 36000*58= 2088000
TOTAL COST….
Normal lensesDirect cost
Rs.2320000+Allocated 2088000
= 4408000
Per unit cost = 4408000/80000=55.1
Complex lenses Direct costRs.1180000 +
Allocated 812000 = 1992000
Per unit cost = 1992000/20000 =
99.6
COST HIERARCHY In ABC, cost pools are often established for each level in a
hierarchy of costs. For manufacturing firms, the following cost hierarchy is commonly identified:
Unit-level costs: For any given product, these costs change in a more-or-less linear fashion with the number of units produced. For example, fabric and thread are unit-level costs for an apparel manufacturer: if the company wants to double production, it will need twice as much fabric and thread.
Batch-level costs: These costs change in a more-or-less
linear fashion with the number of batches run. Machine setup costs are often batch-level costs. The time required to prepare a machine to run one batch of product is usually independent of the number of units in the batch: the same time is required to prepare the machine to run a batch of 100 units as a batch of 50 units. Hence, batch-level costs do not necessarily vary in a linear fashion with the number of units produced.
Product-level costs: These costs are usually fixed and direct with respect to a given product. An example is the salary of a product manager with responsibility for only one product. The product manager’s salary is a fixed cost to the company for a wide range of production volume levels. However, if the company drops the product entirely, the product manager is no longer needed.
Facility-level costs: These costs are usually fixed and direct with respect to the facility. An example is property taxes on the facility, or the salaries of front office personnel such as the receptionist and office manager.
Cost Hierarchy Category Activity/CostFacility-level Plant depreciation
Building rent
Management of facility
Product/customer-level New product development
Product engineering
Product marketing and advertising
Maintaining customer records
Batch-level Machine setups
Processing purchase orders
Batch quality inspections
Unit-level Energy to run production machines
Direct labor
Direct materials
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
ABC differs from traditional cost accounting in three ways.ABC differs from traditional cost accounting in three ways.
Manufacturingcosts
Nonmanufacturingcosts
ABC assigns both types of costs to products.
TraditionalTraditionalproduct costingproduct costing
ABCABCproduct costingproduct costing
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
ABC does not assign all manufacturing costs to products.
Manufacturingcosts
Nonmanufacturingcosts
TraditionalTraditionalproduct costingproduct costing
ABCABCproduct costingproduct costing
All Most, butnot all
Som
e
ABC differs from traditional cost accounting in three ways.ABC differs from traditional cost accounting in three ways.
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
Plantwide Overhead
Rate
Plantwide Overhead
Rate
DepartmentalOverhead
Rates
DepartmentalOverhead
Rates
Activity–BasedCosting
Activity–BasedCosting
Number of cost pools
Lev
el o
f co
mp
lexi
ty
ABC uses more cost pools.
ABC differs from traditional cost accounting in three ways.ABC differs from traditional cost accounting in three ways.
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
Each ABC cost pool has itsown unique measure of activity.
Each ABC cost pool has itsown unique measure of activity.
Traditional cost systems usually relyTraditional cost systems usually relyon volume measures such as direct laboron volume measures such as direct laborhours and/or machine hours to allocatehours and/or machine hours to allocate
all overhead costs to products.all overhead costs to products.
Traditional cost systems usually relyTraditional cost systems usually relyon volume measures such as direct laboron volume measures such as direct laborhours and/or machine hours to allocatehours and/or machine hours to allocate
all overhead costs to products.all overhead costs to products.
ABC differs from traditional cost accounting in three ways.ABC differs from traditional cost accounting in three ways.
ABC uses more cost pools.
ActivityAn event that causes the consumption of overhead
resources.
Activity Cost Pool
A “cost bucket” in which costs related to a single activity measure are accumulated.
$
$
$ $
$$
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
Activity MeasureActivity
Measure
An allocation basein an activity-based
costing system.
An allocation basein an activity-based
costing system.
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
The term cost driver is also used to refer
to an activity measure.
The term cost driver is also used to refer
to an activity measure.
Simple countSimple countof the number ofof the number oftimes an activitytimes an activity
occurs.occurs.
Transactiondriver
A measureA measureof the amountof the amountof time neededof time neededfor an activity.for an activity.
Durationdriver
Two common types of activity measures:
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
HOW COSTS ARE TREATED UNDERACTIVITY–BASED COSTING
Traditional cost systems usually rely on volumeTraditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinemeasures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.hours to allocate all overhead costs to products.
Traditional cost systems usually rely on volumeTraditional cost systems usually rely on volumemeasures such as direct labor hours and/or machinemeasures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.hours to allocate all overhead costs to products.
ABC definesABC definesfive levels of activityfive levels of activity
that largely do not relatethat largely do not relateto the volume of unitsto the volume of units
produced.produced.
MERITS OF ABC• Brings accuracy and reliability in product cost
determination by focusing on cause and effect relationship in the cost incurrence.• Recognizes that activities creates costs , not products• It is product which consumes activities.
• ABC provides more realistic product costs in advanced service or support driven environment
• Behavior of many fixed overhead costs in relation to activities now become more visible and clear.• Helps in reducing costs and identifying activities which
do not add value• Uses multiple cost drivers which are transaction based
rather than volume based
MERITS OF ABC
ABC traces costs to areas of managerial responsibility, process, customers, department besides the product costs.
It improves greatly the manager’s decision making .
Produce reliable and correct cost data in case of diversity
Very useful for cost management. Cost driver rates can be used for design of
new / exixting products as hey indicate overhead costs that are likely to be applied in costing of the product.
DEMERITS OF ABC
Complex system Requires lot of records and tedious
calculation Not suited for small organizations Sometimes it is difficult to attribute costs to
single activities as some costs support several activities.
Difficult in implementation Different level of utility for different firms. Costly to manage Only successful if there is total support from
top management.
IMPLEMENTINGACTIVITY-BASED COSTING
Step 1 Step 2
Identify cost objects. Identify the direct costsof the products.
NLCL
Direct materialDirect labor
Mold cleaning and maintenance
Cleaning and maintenance costs of360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’wages for cleaning molds after each
batch of lenses is run.
IMPLEMENTINGACTIVITY-BASED COSTING
IMPLEMENTINGACTIVITY-BASED COSTING
Normal Lenses (NL)Cost Hierarchy
Description CategoryDirect materials Unit-level 1,520,000Direct mfg. labor Unit-level 800,000Cleaning and maint. Batch-level 160,000Total direct costs 2,480,000
IMPLEMENTINGACTIVITY-BASED COSTING
Complex Lenses (CL)Cost Hierarchy
Description CategoryDirect materials Unit-level 920,000Direct mfg. labor Unit-level 260,000Cleaning and maint. Batch-level 200,000Total direct costs 1,380,000
IMPLEMENTINGACTIVITY-BASED COSTING
Select the cost-allocation bases to use forallocating indirect costs to the products.
(1) (2) (3)Activity Cost Hierarchy Total CostsDesign Product-sustaining 450,000Setups Batch-level 409,200Operations Unit-level 637,500
Step 3
IMPLEMENTINGACTIVITY-BASED COSTING
Identify the indirect costs associatedwith each cost-allocation base.
Overhead costs incurred are assignedto activities, to the extent possible, on
the basis of a cause-and-effect relationship.
Step 4
IMPLEMENTINGACTIVITY-BASED COSTING
Compute the rate per unit.
(1) (5)NL CL Total
Setup-hours: 640 2,000 2,640
Step 5
409,200 ÷ 2,640 = 155
IMPLEMENTINGACTIVITY-BASED COSTING
Compute the indirect costs allocatedto the products.
NL: 155 × 640 = 99,200CL: 155 × 2,000 = 310,000Total 409,200
Step 6
IMPLEMENTINGACTIVITY-BASED COSTING
Compute the costs of the products.
NL and CL would show threedirect cost categories.
Step 7
1. Direct materials
2. Direct manufacturing labor
3. Cleaning and maintenance
IMPLEMENTINGACTIVITY-BASED COSTING
NL and CL would show six indirect cost pools.
1. Design
2. Molding machine setups
3. Manufacturing operations
4. Shipment setup
5. Distribution
6. Administration
ACTIVITY-BASED MANAGEMENT
Activity-based management (ABM) is a method of identifying and evaluating activities that a business performs using activity-based costing to carry out a value chain analysis or a re-engineering initiative to improve strategic and operational decisions in an organization.
Activity-based costing establishes relationships between overhead costs and activities so that overhead costs can be more precisely allocated to products, services, or customer segments.
Activity-based management focuses on managing activities to reduce costs and improve customer value.
TYPES OF ABM
Operational ABM is about “doing things right”, using ABC information to improve efficiency. Those activities which add value to the product can be identified and improved. Activities that don’t add value are the ones that need to be reduced to cut costs without reducing product value.
Strategic ABM is about “doing the right things”, using ABC information to decide which products to develop and which activities to use. This can also be used for customer profitability analysis, identifying which customers are the most profitable and focusing on them more.
EVALUATION OF ABM
The benefits of ABM (and ABC) are greatest in organisations that have high indirect costs.
Users of ABM and ABC often assume that all overhead costs are variable. This is not the case, and some overhead costs will be fixed, so will not be saved if activities are reduced.
ABM is also complex and is expensive to implement. For small businesses, or businesses with narrow product ranges, the benefits of implementing ABM may not justify the costs.
RISK ANALYSIS
A risk with ABM is that some activities have an implicit value, not necessarily reflected in a financial value added to any product.
For instance a particularly pleasant workplace can help attract and retain the best staff, but may not be identified as adding value in operational ABM.
A customer that represents a loss based on committed activities, but that opens up leads in a new market, may be identified as a low value customer by a strategic ABM process.