ABM Assignment

7/23/2019 ABM Assignment

1/7

1

Activity Based ManagementSail Rite

(Marine tools Industry)

CPM Assignment 1

8/15/2015

IIM INDORESOMA BANIK (2014PGP370)


2/7

Activity Based Management Industry Implementation

2

INTRODUCTION TO ABM[5]

Activity based management is a method

that analyzes how a company incurs costs

from its activities that are driven by cost.For this purpose, activity based costing

plays a major role in proportionately

distributing the manufacturing overhead

costs over products in a logical manner.

Activity analysis, cost driver analysis and

performance analysis are the key

dimensions of management under ABM.

An easy example to first explain the ABC

concept and its importance is the burgerand cola example. If a small shop sells

burger and cola and the total time it takes

to prepare the items is 10 hours daily for

equal quantities of burger and cola, say 50,

then the total cost incurred to produce

these items is say Rs 1000. The traditional

costing method assigns a unit cost of

1000/100 = Rs10 to both burger and

cola(since number of units produced for

both are same). But if we look at the actualmachine run hours devoted to making

burger and cola, we find that the system

takes 8 hours to produce burger and only 2

hours for cola. Thus it does not make sense

to assign overhead costs of Rs 500 each to

burger and cola. This problem mentioned

above is explained diagrammatically to get

clarity on ABC.

Product ABC allocation

Burger 1000 x 8/10 = 800Cola 1000 x 2/10 = 200

Cost Driver Machine runs

Burger 800/50 =Rs 16Cola 200/50 = Rs 4

Hence the unit cost becomes Rs 10 for both

burger and cola. This is not a right way ofsplitting overhead costs since we do not

know how much out of the total 10 hours of

machine run activity was given to making

burger and how much to cola. ABC method

defines costs based on activities, machine run

hours in this scenario. There are usually

many activities and cost drivers. So here we

find out that 8 hours are assigned to burger

and 2 hours to cola making. Thus we assign a

higher cost share of 800 to burger and 200 tocola, making the unit cost for burger as Rs 16

and that of cola as Rs 10. This helps the

shopkeeper to come to a decision making

that burgers need to be sold at a higher price

than cola, since the costs incurred to produce

it are more.

By analyzing the relation between

activities and their costs, ABM helps acompanys management to determine

which activities contribute to productive

efficiency and which do not. ABM also

helps making decisions between

profitable and unprofitable product lines,

which ones to be stopped and which ones

to be invested on.


3/7

3

WHY ABM?[2]

1. Desire to improve cost accuracy

2. To know the true profitability

3. Desire to know value added and

non value added costs

4.

Better analyze the ROI from

different projects

5. Support pricing decisions of final

products

[3]As on 2014, national surveys have

reported that the highest percentage of

companies using ABC is in the

manufacturing sector (20-50%)

followed by financial services (25%),public sector (20%) and

communications. After doing a

literature reading on some of the

existing research papers, it is found

that ABC costing has been the base for

cost calculations in many emerging

industries, the new ones being the

hospital, medicine and airline industry.

Every company has adopted the ABC

and made modifications to it to suit totheir organizational needs and goals.

However, the basic steps of ABC

remain the same, being

1. Identifying the cost object

2. Identifying the direct and overhead

costs

3.

Selecting the activities and cost

allocation base for assigning cost

overheads to the cost object4.

Developing the overhead rate per

unit for allocating overhead to the

cost object

ABM ANALYSIS OF SAIL RITE[1]

In this report, I will be discussing the

ABM model of a company called

SailRite. This is owned by Matt and

Hallie Grant and a full stock onlineretailer of fabrics, tools, kits and their

flagship product, sewing machines. It

started in 1969 and slowly began

diversification into not only boats but

also home fabrics.

Sail Rite believes the cost of itsmanufacturing equipments are costly

and it is essential that they keep a

count on which material is used in

which activity to produce what

product. Hence Sail Rite has recently

dived into ABC costing. Sail Rite has a

5-step methodology to ABM.

Before ABC, Sail Rite was aware that

the total overhead costs in the

company were around $8 million.

After evaluating the balance sheets and

other financial statements, the

company accountant came up with the

following activity list:-

Step 1: Identifying activities

contributing to overhead costs

1. Purchasing materials

2.

Machine set ups

3.

Machine runs

4. Assembly of products

5.

Inspecting finished goods

Step 2: Assigning overhead costs to

the activities

Activity Estimated

Annual

Overhead cost

Purchasingmaterials

$1.2 M

Machine set ups $1.6 M

Machine runs $2.7 M

Product assembly $1.5 M

Finished productsinspection

$1 M

Total =$8M


4/7


4

Step 3: Identifying the cost driver for

each activity in step 2

A cost driver is a cause for cost for a

particular activity. It can also be imagined

as the unit of measurement of cost for anyactivity. The following cost drivers were

identified for Sail Rite activities:-

Activity Cost driver Annual cost

driver usage

Purchasingmaterials

Purchaseorders

10,000 orders

Machine setups

# setups 2,000 setups

Machine runs Machinehours

90,000 hours

Productassembly

Direct laborhours

250,000hours

Finishedproducts

inspection

Inspectionhours

20,000 hours

The above information table shows an

estimate of level of activity, which is

further used to calculate activity rates in

the next step. We have still not allocated

the overheads to final products.

Step 4: Calculate a pre-determined

overhead rate for each activity

Overhead Rate = Overhead cost/Level of

cost driver activity

Overhead

costs

Cost driver

activity

Overhead rate

$1.2 M $10,000

orders

120 per order

$1.6 M 2,000 setups 800 per setup

$2.7 M 90,000 hours 30 per machinehour

$1.5 M 250,000hours

6 per labor hour

$1 M 20,000hours

50 perinspection hour

Step 5: Allocating overhead costs to

products as per their utility

The total annual cost driver utilization

calculated in the last column of step 3 is

not used and the total cost is split betweenactivities that have used it. In this example,

the company had allocated these cost

driver usages to 2 major product lines

Basic Sailboat and Deluxe Sailboat.

Activity Basic

Sailboat

Deluxe

Sailboat

Total

Purchasingmaterials

7000orders

3000orders

10,000orders

Machine

set ups

1100

setups

900

setups

2000 setups

Machineruns

50,000hours

40,000hours

90,000hours

Productassembly

200,000hours

50,000hours

250,000hours

Finishedproductsinspection

12,000hours

8,000hours

20,000inspectionhours

The overhead costs are now allocated

based on the above table to the respective

products based on the proportion of theactivity they have utilized during

production (step 4 overhead rate x step 5

allocations of cost driver activity)

Overhead

costs

Basic

Sailboat

Deluxe

Sailboat

Purchasingmaterials

120x7000=840,000

360,000

Machine set

ups

800x1100=880,000

720,000

Machine

runs

30x50000=1,500,000

1,200,000

Product

assembly

6x200,000=1,200,000

300,000

Finished

productsinspection

50x12,000=600,000

400,000

Total 5,020,000 2,980,000

$8,000,000


5/7

5

The overhead cost hence calculated is divided by the total number of units of basic and

deluxe sailboats which are 5000 and 1000 respectively. The overhead unit cost hence comes

out to be

Basic Sailboat = 5.02M/5000 = $1,004

Deluxe Sailboat=2.98mM/1000=$2,980

How is the overhead cost per unit per product used further in the benefit of the company? To

answer this question, we already know that a products cost component is split into 3 parts

Direct Labor, Direct Material and Overhead costs (indirect). The following information about

direct costs is given about Sail rite:-

Sail Rite was initially selling the basic boats at a price of $3,200 gaining a profit of 3200-

2604=$596and deluxe boats at a price of $4,500 having a loss of 5030 4500 = $(530).

With traditional costing, the step 5 would have looked like the following:-

Total costs = $8,000,000

#basic units = 5000 ; #deluxe units = 1000; #unit cost = 8,000,000/6,000=$1,333 per unit

The above table of unit production cost would have then looked like :-

Basic Sailboat Deluxe Sailboat

DM + DL costs per unit 1600 2050

Overhead costs per unit 1333 1333

Total 2933 3383

By selling Basic at $3500, Sail rite thought it was making a profit of 3500 2933 = $517.

By selling Deluxe at $4500, Sail rite thought it was also making a profit of 4500 3383 =

$1117

Actual profits through ABC costing vs expected profits through traditional costing

Basic Sailboat Deluxe Sailboat

Traditional profits $517 $1117

ABC profits (real) $596 ($530) - loss

Hence ABC costing protected the company by helping them decide a price point for deluxe to

make the product profitable, where it had to charge the customer a value greater than $5030.


6/7


6

Recommendationsfor Sail Rite:[4]

1. Economies of scale are not taken into account in ABC method. For such kind of

industries where there is a possibility of making more production units by utilizing

more resources, a large portion of overhead costs are actually fixed costs which must

be spread proportionately among number of units produced. For example, if 2,000units of deluxe boats were produced instead of 1000, the product unit cost will vary

accordingly and the new value, say x will now be divided among 2000 units, thereby

reducing the unit production cost. The company then has to dynamically change its

pricing policy since the product can now be sold at a cheaper price with similar or

more profits. Companies must keep this in mind.

2. The number of hours allocated to each activity or product may not lead to efficient

output. Just like if we study for 8 hours a day and achieve some output level, the

same could be achieved in maybe 5 hours if we were more efficient and studied with

more attention. Similarly, actual hours allocated leading to useful production is lessthan what is called the expected production level. As a company grows across its

learning curve, it may be able to surpass this disadvantage over time. ABM can

hence take a progressive approach towards this aspect of ABC costing.

3. We should not rely only on numbers onlythat are derived from ABC techniques. A

strategic goal and vision mission should always be sustained in any solution we

propose. For example, if deluxe boats are currently not profit making and raising the

prices will reduce the demand, we should not simply discard that product line. We

need to find ways to differentiate the deluxe boat so that people are willing to pay a

higher price for it, and simultaneously work on reduction of internal manufacturingcosts over time.

ABM is a strategic approach to

cost management. As the diagram

explains, ABM closes the needs of

short and long range planning in

addition to deployment of

proactive strategy. It is always

aligned to the business model ofthe company and sustains the value

proposition explained by the

company. [6]

4. ABM does not give a

holistic view on Economic Value

Added and other opportunity costs

involved in the business. A

scenario planning and analysis

taking each of these costs in

revenue planning could be a


7/7


7

recommended option for wider acceptance of ABM. [7]

References:

[1]http://catalog.flatworldknowledge.com/bookhub/reader/4402?e=heisinger_1.0-ch03_s03

[2]http://accountingexplained.com/managerial/cost-allocation/

[3]https://www.business-case-analysis.com/activity-based-costing.html

[4]http://www.brighthub.com/office/finance/articles/78752.aspx

[5]http://www.youtube.com/watch?v=ivlI0HvUPQo

[6]http://www.imanet.org/docs/default-

source/thought_leadership/internal_measurement_systems/implementing_activity_based-

management.pdf?sfvrsn=2[7]http://www.salient.com/docs/LIT_ABM.pdf
http://catalog.flatworldknowledge.com/bookhub/reader/4402?e=heisinger_1.0-ch03_s03http://catalog.flatworldknowledge.com/bookhub/reader/4402?e=heisinger_1.0-ch03_s03http://catalog.flatworldknowledge.com/bookhub/reader/4402?e=heisinger_1.0-ch03_s03http://accountingexplained.com/managerial/cost-allocation/http://accountingexplained.com/managerial/cost-allocation/http://accountingexplained.com/managerial/cost-allocation/https://www.business-case-analysis.com/activity-based-costing.htmlhttps://www.business-case-analysis.com/activity-based-costing.htmlhttps://www.business-case-analysis.com/activity-based-costing.htmlhttp://www.brighthub.com/office/finance/articles/78752.aspxhttp://www.brighthub.com/office/finance/articles/78752.aspxhttp://www.brighthub.com/office/finance/articles/78752.aspxhttp://www.youtube.com/watch?v=ivlI0HvUPQohttp://www.youtube.com/watch?v=ivlI0HvUPQohttp://www.youtube.com/watch?v=ivlI0HvUPQohttp://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.salient.com/docs/LIT_ABM.pdfhttp://www.salient.com/docs/LIT_ABM.pdfhttp://www.salient.com/docs/LIT_ABM.pdfhttp://www.salient.com/docs/LIT_ABM.pdfhttp://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.imanet.org/docs/default-source/thought_leadership/internal_measurement_systems/implementing_activity_based-management.pdf?sfvrsn=2http://www.youtube.com/watch?v=ivlI0HvUPQohttp://www.brighthub.com/office/finance/articles/78752.aspxhttps://www.business-case-analysis.com/activity-based-costing.htmlhttp://accountingexplained.com/managerial/cost-allocation/http://catalog.flatworldknowledge.com/bookhub/reader/4402?e=heisinger_1.0-ch03_s03

ABM Assignment

Documents

Transcript of ABM Assignment