ABC Manoj 1

8/7/2019 ABC Manoj 1

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Activity Based Costing

Better Costing for Better Decisions

Presented by :

Manoj Aggarwal

Sr. Manager Finance

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Indirect Costs

Not easily and conveniently traceable tocost objects

Cost element is shared among cost objects

Physically impossible to trace

Not cost effective to trace

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Purposes of Cost Allocation

1. To provide information needed fordecision making.

2. To reduce the frivolous use ofcommon resources.

3. To encourage managers to evaluatethe efficiency of internally providedservices.

4. To calculate the full cost of productsfor financial reporting purposes and fordetermining cost-based prices.

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Purposes of Cost Allocation

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Rationale #1: To Provide Information forDecision Making

From a decision making standpoint, the

allocated cost should measure theopportunity cost of using a company

resource.

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Rationale #2: To Reduce Frivolous Use ofCommon Resources

By not allocating costs, these resources

appear free to the users. But resourcesnever come with zero costs.

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Rationale #4: To Provide Full CostInformation

1. GAAP requires full-costing for external

reporting purposes.

2. In the long-run, all costs must be

covered.

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Process of Cost Allocation

Steps include:

Identify the cost objectives Form cost pools

Select an allocation base to relate

the cost pools to the costobjectives.

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Process of Cost Allocation

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Determining the CostObjective

Cost Objective: Determine the product,

service or department that is to receive

the allocation.

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Determining the Cost Objective

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Forming Cost Pools

Cost pool: A grouping of individual costs,

the sum of which is allocated using a

single allocation base.

Cost pools could include:

1. Departments (maintenance orpersonnel departments)

2. Major Activities (equipment setups)

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Selecting an Allocation Base

1. Allocation Base: Very important to

choose a base that relates the cost

pool to the cost objectives.

2. Allocation should be based on a

cause-and-effect relationship between

costs and objectives.3. If cause-and-effect cannot be

established, other approaches are

used.

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Activity-Based Costing

Purpose

Allocation of indirect costs based on causal activities Attempts to identify direct link between cost and cost

object

Results in better allocation

Does not provide true cost

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Traditional allocation method

Activity-based allocation method

Costs Products

Costs ProductsActivities

First stage Second stage

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Identifies activities required to produce theproduct or service

Determines the cost of the activities

Allocates costs to the cost objectbased on theobjects consumption of activities

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The Problem of Using Only Measures ofProduction Volume to Allocate Overhead

1. Traditionally firms use labor hours or machine

hours as allocation bases for assigning overhead

to products.

2. This assumes that all costs are proportional toproduction volume.

3. Setup costs are not proportional.

4. For example, a setup might work for a 400,000

unit production run just as well as a 200,000

production run.

5. Low-volume items are undercosted and high-

volume items are overcosted.

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The ABC Approach

1. Identify the major activities that cause

overhead costs to be incurred.

2. Group costs of activities into cost

pools.

3. Identify measures of activities (the cost

drivers)

4. Relate costs to products using the cost

drivers.

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The ABC Approach

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Examples of Activities

1. Processing purchase orders.

2. Handling materials and parts.

3. Inspecting incoming material and parts.

4. Setting up equipment.

5. Producing goods using manufacturing

equipment.

6. Supervising assembly workers.

7. Inspecting finished goods.

8. Packing customer orders.

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Examples of Associated Costs

1. Various labor costs.

2. Depreciation.

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Examples of Cost Drivers

1. Number of purchase orders processed.

2. Number of material requisitions.

3. Number of receipts.

4. Number of setups.

5. Number of machine hours.

6. Number of assembly labor hours.

7. Number of inspections.

8. Number of boxes shipped.

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Pros and Cons of ABC

Benefits:

1. ABC is less likely than traditional costing to

undercost or overcost products.2. ABC may lead to improvements in cost

control.

Limitations:1. Expensive relative to traditional system!

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When is ABC Most Useful

Different products place different demands onresources

Problems with current cost allocations due tochanges in products or processes

Better cost information is needed

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You GetWhat You Measure

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ABM: Using ABC for PerformanceManagement

Manage costs Continuous Improvement (Kaizen)

Radical Redesign of Products or Processes (Targetcosting, Business Process Re-engineering)

- Reduce the usage of the cost drivers

- Reduce the cost per unit of the driver

Set prices relative to competition and value

Eliminate unprofitable business

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Activity-Based Management (Four-Steps)

1. Determine major activities.

2. Identify resources used by each activity.3. Evaluate the performance of the activities.

4. Identify ways to improve the effficiency

and/or effectiveness of the activities.

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Step 1: Determine major activitiesthrough interviews and observations

a. Determine customer locations, determine

availability of stock, and prepare delivery

schedules.

b. Pick orders from warehouse.

c. Load trucks.

d. Deliver merchandise.

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Step 1: Determine major activitiesthrough interviews and observations

(continued)

e. Return merchandise to stock if not

acceptable to customer or customer not

home.

f. Wash delivery trucks (each night).

g. Schedule truck for routine service and

nonroutine repairs.

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Step 2: Identify Resources Used By EachActivity (ex.)

1. Return merchandise to stock (e)

a. Different item received than ordered

b. Customer not home at time of delivery

2. Wash delivery trucks (f)a. How many trucks washed per night?

b. Salary/wage costs associated with

employees

c. Cleaning supplies, materials,

equipment depreciation

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Step 3: Evaluate The Performance Of TheActivities

1. Benchmarking.

2. Compare with other firms.

3. How do costs compare with others?

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Step 4: Identify Ways To Improve TheEfficiency And/Or Effectiveness Of The Actvities

1. Suggest improvements based onanalysis.

2. Best practices at other firms.3. Examples: Have sales staff seek customer input. Have clerk call customers the day prior

to delivery to assure someone is home(note: dentists office now do thisregularly).

Consider converting part-time positionsto full-time or outsourcing washing.

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Conclusion

1. ABM focuses on process improvements.

2. ABC focuses on costing.

3. ABM often identifies low hanging fruit, or

costs which are out of line with

benchmarks.

4. ABM can produce substantial returns.

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Overhead Allocation Using ABC

1ST Level Allocation Allocation of Expenses to Sites based upon Cost Center

Accounting

2nd Level Allocation Allocation of Expenses to Respective Machines at

Respective Cost Centers

3

rd

Level Allocation Allocation of Expenses to Respective Products basedupon Principles for Activity Based Costing

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Statutory Warning !

Dont Use A Sledge

Hammer to crack a Nut

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Overhead Allocation

Overhead 1st Stage Allocation 2nd Stage Allocaiton 3rd Stage Allocation

Site Wise Machine Wise Product Wise

Employee Cost - ProductionSitewise Cost Information is

available through System

Machinewise Cost Information is


Direct Machine Hours worked /

Product

Utilities (100%)Sitewise Cost Information is


Machinewise Cost allocation is

done on KWH and Utilization %


Product

Employee Cost Others :-

Associated With ProductionSitewise Cost Information is


Allocated on the basis of Total

Output Tons

Associated With Marketing

Allocated on Customerwise

Sales Value. Further Allocated

to Tonnage sold to that

Others - AdmnAllocated on the basis of Total

Output Tons

MaintenanceSitewise Cost Information is


Machinewise Cost Information is



Product

Rent & Rates + InsuranceSitewise Cost Information is


Standard Output of Machine Per

Month - On Standard Mix


Product

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ABM through BCG Matrix

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BCG Matrix Existing

Val

t

rs

Sta

ar

Basi

Ultra Soft

L

x

ry Soft

Family Val

S

r Soft

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10 %

15 %

20 %

25 %

-200 - 200 400 600 800 1,000 1,200 1,400 1,600

BCG r x - x s Cos

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BCG Matrix After ABC

Value

Others

Standard

Basic

Ultra Soft

Luxury Soft

Family Value

Super Soft

-30%

-20%

-10%

0%

10 %

20 %

30 %

-200 - 200 400 600 800 1,000 1,200 1,400 1,600

BCG Matrix - Proposed Costing

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BCG Matrix After ABC Comparison

Value

Ot

e

Standard

Basic

Ultra S

t

uxury S

t

Family Value

Super S

t

-

-

-

-

-

400 6 00 800 1 ,000 1 ,

00 1,400 1 ,600

BC M ix opos d Cos in

V!

"

u#

$

% h& '

s

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nd! 0

d

1

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3

4

5 %

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6 7 8

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%

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(

C

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)

E

6 F

G

5 HV

6 5u

&

7 up& '

7 8

9

%

-I P

%

-Q R

%

-S T

%

-U R

%

-

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%

- V %

P

%

R

%

W T

%

U R

%

Q P

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-Q P P

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BCa

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Cosc

inf

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BCG Matrix After Target Costing

Value

Others

Standard

Basic

Ultra Soft

Luxury Soft

Family Value

-5%

0%

5%

10 %

15 %

20 %

25 %

0 500 1000 1500 2000 2500 3000 3500

BCG Matrix - After Taget Costing

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ABC Manoj 1

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