Published on March 6, 2014
Activity Based Costing (ABC)
In the past, overhead costs were relatively small, and the problems arising from inappropriate overhead allocations were not so significant But nowadays, factories are highly automated, resulting in increasing depreciation charges, maintenance cost and machinery set-up cost Errors in overhead absorption may seriously affect the management decisions 2
The Activity-based costing (ABC) system is developed to provide better approach for assigning overheads to products and computing product costs. 3
Today’s businesses are working in an increasingly complex environment because of….. Use of Advanced Technology Product Life Cycle Product Complexity Channels of Distribution Quality Requirements Product Diversity
Direct materials and direct labor costs are easy to trace Overhead cannot be traced easily and must be assigned with estimates
Spreads overhead cost over entire customer base. Each order “appears” to cost the same. Orders with high profit margins subsidize orders with low profit margins
A single or plant wide rate called a predetermined overhead rate is used: Job Order = Direct Labor Costs Process Cost = Machine Hours
Amount of direct labor used in many industries has decreased Total overhead from depreciation on equipment, utilities, repairs, maintenance has increased
Conventional Costing Expenses AB Costing Economic Element Resources Activities Work Performed Cost Objects Product or service Cost Objects
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 • The primary objective of ABC is to assign costs that reflect/mirror the physical dynamics of the business
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.
Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.
The overhead cost allocated to a distinct type of activity or related activities.
Any factor or activity that has a direct cause-effect relationship with the resources consumed. In ABC cost drivers are used to assign activity cost pools to products or services.
Steps in ABC Costing Cost pools are groups or categories of individual expense items Steps: 1. Form cost pools 2. Identify activities 3. Map resource costs to activities 4. Define activity cost drivers 5. Calculate cost
In developing an ABC system, the organization identifies the activities being performed: Activity Dictionary •Move material •Respond to customers •Schedule production •Purchase material •Inspect items •Improve products •Introduce new products •Explore new markets
Financial accounting categorises expenses by spending code; salaries, fringe benefits, utilities, travel, communication, computing, depreciation etc. •ABC collects expenses from this financial system and drive them to the activities performed.
Mapping Accounting Records Salaries 313,000 Activities Business Development ABC Records Salaries Depreciationlectricity Supplies Travel E 20,000 25000 5000 Total 5000 55,000 Depreciation 155,000 Maintianing Present Business 80,000 60000 50000 5000 10000 205,000 Electricity 132,000 Purhcasing Material 125,000 50000 20000 20000 60000 275,000 Supplies 25,000 Set up Machines 25,000 10000 2000 37,000 Travel 100,000 Running Machines 50,000 10000 50000 110,000 Total 725,000 Resolve Quality Problems 13,000 5000 25000 43,000 Total 313,000 155000 132000 25000 100000 725,000
Activities: Types • Unit level: Performed each time a unit is produced • Batch level: Performed each time a batch is produced • Product level: Performed to support production of different type of product • Facility level :Residuary head
I. Unit-level activities The costs of direct materials, direct labor, and machine maintenance are examples of unit-level activities. I. Batch-level activities are costs incurred every time a group (batch) of units is produced . Purchase orders, machine setup, and quality tests are examples of batch-level activities. I. Product-line activities Examples of product-line activities are engineering changes made in the assembly line, product design changes, and warehousing and storage costs for each product line. I. Facility support activities The costs relating to the activities are administrative in nature and include building depreciation, property taxes, plant security, insurance, accounting, outside landscape and maintenance, and plant management's and support staff's salaries.
The linkage between activities and cost objects, such as products, customers,, is accomplished by using activity drivers. An activity driver is a quantitative measure of the output of an activity. The selection of an activity driver reflects a subjective trade-off between accuracy and cost of measurement.
Activitie s Drive rs Unit Le ve l Acquire and Use material f or containers Acquire and Use material f or baby-care products No. of Containers No. of products Batch Le ve l Set up manually controlled machines Set up computer controlled machines No. of batches of containers No. of batches of B. Produst Product Le ve l Design and manuf acture moulds Use manually controlled machines Use conputer controlled machines No.of moulds required Product type (containers) Product type (B.Products) Cus tom e r Le ve l Consult customers Provide w arehousing f or customers No. of consultations No. of cubit f eet Faciltiy Le ve l Manage w orkers Salaries
Activities Drivers Unit Level Acquire and Use material for containers No. of Containers Acquire and Use material for baby-care products No. of products Batch Level Set up manually controlled machines No. of batches of containers Set up computer controlled machines No. of batches of B. Produst Activity Cost Activity Volume Activity Rate 40,000 80,000 1,000,000 8,000 0.04 10 3,000 12,000 10 20 300 600 5,000 15,000 40,000 5 1 1 1000 15000 40000 4,000 2,000 40 10,000 100 0.2 3,000 48,000 15,000 16,000 0.2 3 Product Level Design and manufacture moulds No.of moulds required Use manually controlled machines Product type (containers) Use conputer controlled machines Product type (B.Products) Customer Level Consult customers No. of consultations Provide warehousing for customers No. of cubit feet Faciltiy Level Manage workers Salaries Use main building Square feet
Ascertaining Cost Activities A. Rate A.Volume Containers Baby Product Unit Level Acquire and Use material for containers 0.04 1,200,000 48,000 Acquire and Use material for baby-care products 10 7,000 70000 Batch Level Set up manually controlled machines Set up computer controlled machines 300 600 12 16 3,600 1 4 1 1 1,000 9600 Product Level Design and manufacture moulds Use manually controlled machines Use conputer controlled machines 1000 15000 40000 4000 15,000 40000 Customer Level Consult customers Containers B.products Provide warehousing for customers Containers B.products Faciltiy Level Manage workers Containers B.products Use main building Containers B.products Total Cost 100 2 40 200 8,000 2,000 1,600 4,000 10,000 800 5,000 7,000 15,000 4000 0.2 400 0.2 2000 3 85,200 21000 151,000
More accurate product costing which necessitates: More cost pools used to assign overhead Enhanced control over overhead Better management decisions
Products differ greatly in volume and manufacturing complexity Products lines are numerous diverse 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
An extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making.
An activity that increases the worth of a product or service such as... engineering design machine set-ups machining assembling painting packaging
An activity that adds cost to, or increases the time spent on, a product/service without increasing its market value such as: Repair of machines Storage of inventory Moving of materials Building maintenance Inspections Inventory Control
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