Activity Based Costing
Activity Based Costing
Activity Based Costing
COURSE OBJECTIVES
To understand the link between costs and changes in volumes and profitability To explain the use and demonstrate the analysis of management accounting information for managerial decision making. To explain the application of financial and operational measures for managerial decision making and performance evaluation
Background
Recall that Factory Overhead is applied to production in a rational systematic manner, using some type of averaging. There are a variety of methods to accomplish this goal. These methods often involve tradeoffs between simplicity and realism Simple Methods Unrealistic Complex Methods Realistic
Broad Averaging
Historically, firms produced a limited variety of goods while their indirect costs were relatively small. Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred
Cross-subsidization
The results of overcosting one product and undercosting another. The overcosted product absorbs too much cost, making it seem less profitable than it really is The undercosted product is left with too little cost, making it seem more profitable than it really is
An Example: Plastim
An activity is an event, task or unit of work with a specified purpose. Eg Designing products, setting up of machines, operating machines, distributing products, etc. Activities are usually verbs- things a firm does.
Major Activities
Associated Costs
Cost Driver
Processing purchase Labour costs for workers determining order for materials and order quantities, contacting vendors, parts and preparing purchase orders
Labour costs for workers handling material and parts, depreciation of equipment used to move material and parts
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
Major Activities
Associated Costs
Cost Driver
Producing goods using Depreciation on manufacturing manufacturing equipment equipment Salary of assembly supervisors
Number of machine-hours
Supervising assembly
Labour cost for finished goods inspections, Workers Inspecting depreciation of equipment finished goods used to test whether finished goods meet customer specifications, etc.
Number of inspections
A company produces two products, A and B, and estimates that its overhead costs will be Rs. 2,61,780. Overhead has traditionally been allocated on the basis of direct labor hours. Estimated data follow:
Product A 500 units 1 Product B 1,250 units 2
Estimated Activity Product A Product B 20 (nos) 26 1,620 (Sqft.) 2,540 56 (nos.) 288
Solution
Activity centre rates:
Setups Maintenance Inspections 27,140/46 = 590 / setup 183,040/4,160 = 44/sq. ft. 51,600/344 = 150/inspection
TC 87.26 174.52 ABC 182.96 136.24
Conclusions
Each method is mathematically correct Each method is acceptable Each method yields a different cost figure, which will lead to different Gross Margin calculations Only Overhead is involved. Total Costs for the entire firm remain the same they are just allocated to different cost objects within the firm Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a costbenefit analysis of each option under consideration
A Cautionary Tale
A number of critical decisions can be made using this information;
Should one product be pushed over another? Should one product be dropped?
Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.
Cost Hierarchies
ABC uses a four-level cost structure to determine how far down the production cycle costs should be pushed:
Unit-level (output-level)-activities performed for each unit of production- machine op costs Batch-level- activities performed for each batch of unitsmachine set up Product- sustaining-level-activities to support products irrespective of nos. produced- designing Facility-sustaining-level-support organization as a wholeCEO salary
Activity-Based Management
A method of management that used ABC as an integral part in critical decision-making situations, including:
Pricing & product-mix decisions Cost reduction & process improvement decisions Design decisions Planning & managing activities
SBI earns interest spread of 3 percent on average deposits Depositors with less than Rs. 1000 balance pay penalty of Rs. 20 per month. Assume Arvinder always has an average balance < 1000
particulars Dep/wd with teller Dep/wd with ATM AB Cost per Nitin trans. 2.50 0.80 40 10 Arvinder 50 20 Sanjay 5 16
Other dep/wd
Cheques FC drafts Inquiries Avg premier account balance
0.50
8 12 1.5
0
9 4 10 1100
12
3 1 18 800
60
2 6 9 25000