Activity Based Costing
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The document discusses Activity Based Costing (ABC), explaining its necessity in today's complex business environments and how it improves cost allocation compared to traditional costing systems. It outlines ABC's methodology, which involves identifying activities that drive costs and allocating those costs to products based on usage, thereby enhancing accuracy in product costing. Additionally, it highlights the benefits and limitations of ABC, emphasizing its role in facilitating better pricing decisions while acknowledging the challenges of implementation.
![Illustration – Traditional Costing System
Particulars
Blue
Pens
Black
Pens
Red
Pens
Purple
Pens
Total
(1) (2) (3) (4) (5)
Production/Sales volume 25,000 20,000 4,500 500 50,000
Unit sale price 45 45 46.5 49.5
Sales (a) 11,25,000 9,00,000 2,09,250 24,750 22,59,000
Material costs 3,75,000 3,00,000 70,200 8,250 7,53,450
Direct labour costs 1,50,000 1,20,000 27,000 3,000 3,00,000
Overheads (300% of Direct
Labour)
4,50,000 3,60,000 81,000 9,000 9,00,000
Total costs (b) 9,75,000 7,80,000 1,78,200 20,250 19,53,450
Total operating income
[(a) – (b)]
1,50,000 1,20,000 31,050 4,500 3,05,550
Return on sales (%) 13.3 13.3 14.8 18.2 13.5
Montex PenTotal and Product Profitability (Amt. in Rs.)](https://image.slidesharecdn.com/abc-140828055502-phpapp02/85/Activity-Based-Costing-24-320.jpg)
Activity Based Costing
- 1. By: Vikas Gupta Date: 9th August 2014 Activity Based Costing
- 3. Structure Traditional Costing System1. Need for Activity Based Costing System2. History Behind Activity Based Costing System3. ABC – What is it?4. ABC – Who is involved in it?5. ABC – When do we use it?6. ABC – Objectives7. Worked Example – Traditional Costing Vs ABC8. ABC – Benefits and Limitations9.
- 4. Traditional Costing Systems • Product Costs – Direct labor – Direct materials – Factory Overhead • Period Costs – Administrative expense – Sales expense Appear in the P&L when goods are sold, prior to that time they appear in the balance sheet as inventory. Appear in the P&L in the period incurred.
- 5. Traditional Costing Systems • Product Costs – Direct labor – Direct materials – Factory Overhead • Period Costs – Administrative expense – Sales expense Direct labor and direct materials are easy to trace to products. The problem comes with factory overhead.
- 6. Traditional Costing Systems • Typically used one rate to allocate overhead to products. • This rate was often based on direct labor cost or direct labor hours. • This made sense, as direct labor was a major cost driver in early manufacturing plants. • Manufacturing processes and the products they produce are now more complex. • This results in over-costing or under-costing. – Complex products are not allocated an adequate amount of overhead costs. – Simple products get too much.
- 7. Need for ABC 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
- 8. Need for ABC As the business grows overhead takes a larger pie in the total cost of the product and hence it is important to charge it accurately and more scientifically 0 50 100 1 2 3 4 Composition of Cost Direct Material Labour Overheads
- 9. History behind ABC ABC became practiced in the early 1980’s but it has really become a force in industry in the mid to late 1990’s Most current approaches to ABC are based on concepts developed by the Computer Aided Manufacturing-International (CAM-I) Project Since then ABC plans have been further developed and diversified down to mid and small size companies
- 10. ABC – What is it? ABC is the Activity Based Cost accounting method. ABC focuses on identifying all activities associated with making a product or doing a process.
- 11. ABC – What is it? ….(contd.) Activity = Cost Identifying activities will yield a total cost system.
- 12. ABC – What is it? Conventional Costing Expenses Cost Objects Resources Activities Cost Objects Product or service Work Performed Economic Element Activity Based Costing ABC System is based on activities, linking spending on resources to the products/services produced/delivered to customers. It uses a two-stage overhead allocation: (i)Tracing costs to activities (ii)Tracing costs from activities to products/jobs
- 13. Tracing Cost to Activities This step is to identify major activities that cause/drive overhead costs to be incurred. Some of the activities are related to production volume (such as production runs, salary of supervisors and so on) but others are not (such as inspection/handling of materials, setting up equipment and so on). The cost of resources consumed in performing these activities are grouped into cost pools.
- 14. Tracing Cost to Activities Common Activities Associated Costs Cost Driver Processing purchase order for materials Labour costs for workers determining order quantities, contacting vendors, and preparing purchase orders Number of purchase orders processes Handling material Labour costs for workers handling material, depreciation of equipment used to move material Number of material requisitions Inspecting incoming material Labour costs for workers performing inspections, depreciation of equipment used to test strength of materials, tolerances, etc. Number of receipts Setting up equipment Labour costs for workers involved in setups, depreciation of equipment used to adjust equipment Number of setups Producing goods using manufacturing equip. Depreciation on manufacturing equipment Number of machine- hours Supervising assembly workers Salary of assembly supervisors Number of assembly labour-hours Inspecting finished goods Labour cost for finished goods inspections, depreciation of equipment used to test whether finished goods meet customer specifications, etc. Number of inspections Packing customer orders Labour cost for packing workers, cost of packing materials, etc. Number of boxes packed
- 15. Tracing Costs from Activities to Products The next step is to assign costs to products/jobs using cost drivers as a measure of activity. Cost drivers represent the quantity of activities used to produce individual products. They identify the linkage between activities and cost objects and serve as quantitative measures of the output of activities. In fact, they are the central innovation of ABC system.Three types of cost drivers are: (I) Transaction (II) Duration (III) Intensity (Direct charging)
- 16. Tracing Costs from Activities to Products Transaction drivers are used to count the frequency of an activity/the number of times an activity is performed. Duration drivers represents the amount of time required to perform an activity. Intensity drivers are used to charge directly for the resources used each time an activity is performed. Transaction Drivers Duration Drivers Intensity Drivers
- 17. Preparation of ABC product profitability report The next step is to compute the Activity Cost Driver Rate (ACDR). The ACDR is the amount determined dividing the activity expenses by the total quantity of the activity cost driver. Finally, ABC Products Profitability Report is prepared. It combines activity expenses assigned to each product with their direct (labour and material) costs. The activity expenses assigned to a product is arrived at multiplying the ACDR by the quantity of each activity cost driver used by each product. Activity Cost Driver Rate Activity-Based Costing Products Profitability Report
- 18. Who is involved in it? Engineers Accountants Management Factory workers Supply Chain Management personnel Sales ……………….EVERYONE!
- 19. ABC Terms • work performed within an organizationActivity • financial input consumed by activitiesResource • any measure of the quantity of resources consumed by activitiesResource Driver • any measure of the frequency and intensity imposed by a cost objectActivity Driver • any customer, service, process that requires a separate cost measurementCost object
- 20. ABC Costs Cost Element Cost Element Cost Activity Cost Activity Cost Activity Cost Pool - A Cost Pool - B Cost Pool - C Product Resource Driver Business Process
- 21. ABC – When do we use it? When one or more of the following conditions are present: Product lines differ in volume and manufacturing complexity. Product lines are numerous and diverse, and they require different degrees of support services. Overhead costs constitute a significant portion of total costs.
- 22. ABC – When do we use it? …(contd.) The manufacturing process or number of products has changed significantly - for example, from labor intensive to capital intensive automation. Production or marketing managers are ignoring data provided by the existing system and are instead using “bootleg” costing data or other alternative data when pricing or making other product decisions.
- 23. ABC – Objectives • The primary objective of ABC is to assign costs that reflect / mirror the physical dynamics of the business • 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.
- 24. Illustration – Traditional Costing System Particulars Blue Pens Black Pens Red Pens Purple Pens Total (1) (2) (3) (4) (5) Production/Sales volume 25,000 20,000 4,500 500 50,000 Unit sale price 45 45 46.5 49.5 Sales (a) 11,25,000 9,00,000 2,09,250 24,750 22,59,000 Material costs 3,75,000 3,00,000 70,200 8,250 7,53,450 Direct labour costs 1,50,000 1,20,000 27,000 3,000 3,00,000 Overheads (300% of Direct Labour) 4,50,000 3,60,000 81,000 9,000 9,00,000 Total costs (b) 9,75,000 7,80,000 1,78,200 20,250 19,53,450 Total operating income [(a) – (b)] 1,50,000 1,20,000 31,050 4,500 3,05,550 Return on sales (%) 13.3 13.3 14.8 18.2 13.5 Montex PenTotal and Product Profitability (Amt. in Rs.)
- 25. Illustration – Activity Based Costing Let us now do a step-wise cost allocation of overhead costs and prepare ABC Products Profitability Report for the Montex Pen Manufacturing Company as per data provided in previous example (A) The total overheads (aggregating Rs 9,00,000) were comprised of the following: Expense category Expenses (Rs) Indirect labour Fringe benefits Computer system expenses Machinery Maintenance Energy Total 3,00,000 2,40,000 1,50,000 1,20,000 60,000 30,000 9,00,000
- 26. Illustration – Activity Based Costing The activities and activity expenses of the Company are summarised below: Overhead cost items Cost driver Total expenses (Rs.) Handle production runs Set up Support machines Run machine products Indirect labour and 1/2 fringe benefits 50% 40% 10% — 4,20,000 Computer expenses 80% — 20% — 1,50,000 Machine depreciation — — — 100% 1,20,000 Maintenance — — — 100% 60,000 Energy Activity — — — 100% 30,000 Expenses (Rs.) 3,30,0001 1,68,0002 72,0003 2,10,0004 7,80,000 1 (Rs 4,20,000 × 0.50) + (Rs 1,50,000 × 0.80) = Rs 2,10,000 + Rs 1,20,000 = Rs 3,30,000 2 (Rs 4,20,000 × 0.40) = Rs 1,68,000 3 (Rs 4,20,000 × 0.10) + (Rs 1,50,000 × 0.20) = Rs 42,000 + Rs 30,000 = Rs 72,000 4 (Rs 1,20,000 + Rs 60,000 + Rs 30,000) × 1.00 = Rs 2,10,000 Step 1
- 27. Illustration – Activity Based Costing Activity Cost Driver Products Blue Pens Black Pens Red Pens Purple Pens Total@ Direct labour-hour/unit 0.02 0.02 0.02 0.02 1,000 Machine-hour/unit 0.20 0.20 0.20 0.20 10,000 Production runs 70.00 65.00 50.00 15.00 200 Setup time/run 4.00 2.40 5.60 5.60 — Total setup time (hour) 280.00 156.00 280.00 84.00 800 Number of products 1.00 1.00 1.00 1.00 4 @Total labour and machine-hours are obtained by multiplying the unit amounts by the quantity of each type of pen sold, that is, 25,000 blue, 20,000 black, 4,500 red and 500 purple pens. Step 2
- 28. Illustration – Activity Based Costing Step 3 The activity cost driver rates and the activity expenses assigned to products are shown below: Activity Activity expenses Activity cost driver Activity cost driver quantity Activity cost driver rate Handle Production runs 3,30,000 Number of production runs 200 Rs 1,650 per run Set up machines 1,68,000 Number of setup hours 800 Rs. 210 per setup Hour Support products 72,000 Number of products 4 Rs. 18,000 per Product Run machines 2,10,000 Number of machine-hours 10,000 Rs. 21 per machine-hour Total 7,80,000
- 29. Illustration – Activity Based Costing Step 4 Activity Expenses Assigned to Products Activity ACDR ACDQ for Blue Activity Exp.: Blue ACDQ for Black Activity Exp.: Black ACDQ for Red Activity exp.: Red ACDQ for purple Activity Exp.: Purple (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Handle Production Run 1,650 70 1,15,500 65 1,07,250 50 82,500 15 24,750 Setup Machines 210 280 58,800 156 32,760 280 58,800 84 17,640 Support Products 18,000 1 18,000 1 18,000 1 18,000 1 18,000 Run Machines 2.10 5,000 1,05,000 4,000 84,000 900 18,900 100 210 Note: ACDR = Activity Cost Driver Rate; ACDQ = Activity Cost Driver Quantity
- 30. Illustration – Activity Based Costing Exhibit 3 Activity-Based Costing Products Profitability Report Particulars Blue Pens Black Pens Red Pens Purple Pens Total Sales revenues 11,25,000 9,00,000 2,09,250 24,750 22,59,000 Material cost 3,75,000 3,00,000 70,200 8,250 7,53,450 Direct labour cost 1,50,000 1,20,000 27,000 3,000 3,00,000 Overheads: 50% fringe benefit on direct labour 60,000 48,000 10,800 1,200 1,20,000 Handle production runs 1,15,500 1,07,250 82,500 24,750 3,30,000 Setup machines 58,800 32,760 58,800 17.640 1,68,000 Support products 18,000 18,000 18,000 18,000 72,000 Run machines 1,05,000 84,000 18,900 2,100 2,10,000 Total 3,57,300 2,90,010 1,89,000 63,690 9,00,000 Operating income 2,42,700 1,89,990 (76,950) (50,190) 3,05,500 Return on sales(%) 21.7 21.1 (36.8) (202.8) 13.5
- 31. ABC– Benefits and Limitations More accurate and informative product costs lead to better pricing decisions. The activities driving costs are more accurately measured. Managers gain easier access to the relevant costs. An ABC system is very expensive to develop and implement, and very time-consuming to maintain.
- 32. QUESTIONS?