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

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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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