Activity Based Costing

Activity Based Costing

Karpagam University and Rajanarayan Textiles Ltd

14.09.2010

Rajanarayan Textiles Ltd

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Activity Based Costing2

Activity Based Costing 1.Meaning and methodology of ABC 2.Merits and De-merits 3.Suitability of Activity Based Costing 4.Implementation of Activity Based Costing 5.Drawback of conventional costing.Rajanarayan Textiles Ltd

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What is ABC?Activity based costing is an accounting methodology that assigns costs to activities rather than products or services This enables resource and overhead costs to be more accurately assigned to the products and the services that consume them


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Cost Management Systems4

Objectives

Measure

the cost of resources consumed. Identify and eliminate non-value-added costs. Determine the efficiency and effectiveness of all major activities. Identify and evaluate new activities that can improve future performance.Rajanarayan Textiles Ltd 14.09.2010

Gaining Improved Insight Into the Work Performed at each level of the OrganizationTraditional Cost Accounting Resources Resources are directly assigned to outputs Indirect costs are allocated No visibility into the work performed

Activity-Based Costing Resources Resources are assigned to work activities

NEW WAY

Business Processes/ Provides visibility into the cost of work Activities performed Provides visibility into the causes of cost

Products/Services14.09.2010 Rajanarayan Textiles Ltd

Products/Services/ Customers5

Activity Based CostingMeaning and Methodology of ABC6

Modern Business environment. To identify and eliminate the non-value added activities. Right price for the right customers. ABC system aims at reducing product cost. ABC system focuses on activities required to produce each product. ABC improves the accuracy of product costing.


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Traditional Allocation Method Indirect costs allocated to cost object based

on the cost object s consumption of some measure of activity, usually labor hours$10,000,000 total indirect cost 400,000 total labor hours = $25 per hour rate

A product consuming 6 labor hours would be charged $150 of indirect costs


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Activity-Based Costing Traditional allocation methodCosts Products

Activity-based allocation methodCosts First stage Activities Products Second stageRajanarayan Textiles Ltd 14.09.2010

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ExampleTraditionalSalaries Equipment Supplies Overhead TOTAL $100 $80 $20 $45 $245

ABCClean door $40 Paint door $75 Inspect door $75 Send door to assembly $55 TOTAL $245


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Activity Based CostingActivitiesCost are assigned first to activities. Activities are driven by sub elements called cost drivers.

ExampleDelivering a letter is an activity. Mode of transport is cost driver. Cycle - Labor cost only. Motor cycle Labor + Fuel + Interest Car Labor + Fuel + Interest

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Activities

Value added activities

Non Value added activities




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Activity Based Costing

ABC is the concept to adopt. ABC is not the system to install There can t be uniform ABC systems for varied firms. Better costing for better decisions.


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Activity Based CostingMethodologyProduct flow diagram Identifying the major activities Identifying the cost drivers Indirect Labor and Fixed cost allocation to each and every unit of machines on day basis linked to utilization.

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MeritsABC Provides more comprehensive detail about product costs. It generates data that is more specific and Reliable than traditional costing. Overheads are distributed precisely. It provides better information about the cost of activities Better decisions. It improves cost control.


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DemeritsABC can be costly and difficult to implement. Trained and experienced staffs are required to operate the system. Substantial IT-ERP costs may be required. It uses predetermined rates .


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Suitability of ABC CostingABC is best suited for business High competitive market Many products Complex production process Manufacturing/Production Service Hospitals/Educational Institutions Government Organizations


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When is ABC Most Useful?

High amounts of overhead cost Multiple products Complex products Complex production system Significant variation in volume between high and low volume products


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High Overheads Product Diversity or Multiple Products Customer Diversity Service Diversity Stiff Competition

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When ABC is neededABC accounting is a technique for understanding costs. ABC offers more accurate cost accounting. ABC offers limited benefits to companies producing narrow range of similar products. ABC benefits to companies producing highly diversified range with high volume and low volume products. Low Margin Highly volatile market Stiff competition Complexity of product mix-------It is time to implement ABC.14.09.2010 Rajanarayan Textiles Ltd 19

Todays businesses are working in an increasingly complex environment. Use of Advanced Technology Product Life Cycle Product Complexity Channels of Distribution Quality Requirements Product DiversityRajanarayan Textiles Ltd 14.09.2010

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Why it is important Now? During 1980s .Low capital intensive Labor cost - 40%. Raw material cost 50%. Fixed/Indirect cost -10%.

After1990s .High capital intensive. Labor cost 10%. Raw material cost- 50%. Fixed/Indirect Cost 40%.Rajanarayan Textiles Ltd 14.09.2010

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Implementation of ABCResistance to change is the first hurdle.(Behavioral.1) Individual factors.(Leader). Organizational (2) factors-Routines to promote. Technological (3) hurdles. Process Knowledge to accountant.

Activity Based Costing14.09.2010 Rajanarayan Textiles Ltd 22

Not easily and conveniently traceable to cost objects

Cost element is shared among cost objects Physically impossible to trace Not cost effective to trace

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Activity Based CostingDeveloping an ABC systemABC is clearly a team effort. Representation from Operation, Engineering and Accounting. Familiar with principles of ABC. Documentation. Understanding the processes. Identify the major activities.(Fishbone Diagram). Identify the cost drivers.


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Fishbone DiagramDr.Ishikawa Year 1982Category 1Factor Factor Factor

Category 2Factor Factor

Topic NameFactor Factor Factor Factor

Category 3

Category 4

Factors and/or categories of factors


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3rd Largest CauseCause Cause Cause

Largest InfluenceCause Cause

EffectCause Cause Cause Cause

Least Influence

2nd Largest Influence



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3rd Labour WagesCause Cause Cause

1St Raw MaterialCause Cause

EffectCause Cause Cause Cause

Least Commission

2nd Power


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Activity Based ManagementABM uses the information provided by ABC costing. Process Improvement. Identify non value added activities. Cost reductionLean Manufacturing. Continual improvement. Kaizen Costing. Managing the activities.


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Co-co Cola Implemented ABCMature ABC user .Implemented for two reasons 1.For getting reliable datas for day to day control. 2.To use the ABC outputs for Lean Manufacturing Six Sigma Value Re-engineering Target costing Product rationalization and Customer profitability .Rajanarayan Textiles Ltd 14.09.2010

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ABC is Optional or RequiredABC is simply a data. ABC is cost modeling. Controllable cost. ABC is work-centric . Moto of ABC It is better to be approximately correct than precisely inaccurate.


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ABC is Optional or RequiredToday, organizational road is no longer long and straight and it winds around bends and hills . Today with IT ,developing an ABC system is not so difficult . ABC datas are imported and exported for CRM Customer Relationship Management DSS-Decision support system ABB Activity based budgeting EIS Executive information system.Rajanarayan Textiles Ltd 14.09.2010

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Product Diversity Aerotech is likely to Can you identify any problemsface as a result of this distortion?Mode I Traditional costing $ 209.00 ABC costing 183.44 Cost distortion per unit 25.56 Units produced 10,000 Total cost distortion 255,600 Mode II $ 302.00 261.81 40.19 20,000 803,800 Mode III $ 126.00 390.85 (264.85) 4,000 (1,059,400)

Traditional costing understates the cost of complex, low volume products.14.09.2010 Rajanarayan Textiles Ltd 34

Uncertainty in ABC input dataActivity Drivers Activity pools Activity level ..historical or estimated data. Extensive data requirement Input data are often estimated .


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ActivityActivity-Based Costing in Service BusinessesHopewell HospitalActivity-Based CostingAdmitting Radiological Testing Operating Room Pathological Testing Dietary and Laundry$180 per admission $320 per image $200 per operating room hour $120 per specimen $150 per day36

P A T I E N T S


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Activity Costs Allocated to a PatientPatient Name: Mary Wilson Activity Admitting Radiology testing Operating room Pathological testing Dietary and laundry Total Activity-Base Usage 1 admission 2 images 4 hours 1 specimen 7 days Activity Activity Rate Cost x $180 = $ 180 x 320 = 640 x 200 = 800 x 120 = 120 x 150 = 1,050 $2,790

The overhead cost associated with services can be related to the customers that use the service.

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Customer Profitability ReportHopewell Hospital Customer (Patient) Profitability Report For the Period Ending December 31, 2006 Adcock, Birini, Conway, Kim Brian Don Revenues $9,500 $21,400 $5,050 Less: Patient costs Drugs and supplies $ 400 $ 1,000 $ 300 Admitting 180 180 180 Radiological testing 1,280 2,560 1,280 Operating room 2,400 6,400 1,600 Pathological testing 240 600 120 Dietary and laundry 4,200 14,700 1,050 Total patient costs $8,700 $25,440 $4,530 Income from operations $ 800 $ (4,040) $ 520

Wilson, Mary $3,300 $ 200 180 640 800 120 1,050 $2,990 $ 31038

Activity Based Costing System (ABC)ABC systems follow a two-stage procedure to assign overhead costs to products.Assigning overhead to products is a difficult process.

I agree!

Activity Based Costing System (ABC)ABC systems follow a two-stage procedure to assign overhead costs to products.Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used.Lets begin by identifying our major activities.

Direct costs are physically traced to a cost object. Indirect costs are allocated using a cost-allocation base. cost-


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Direct materials include the acquisition costs of all materials that a company identifies as a part of the manufactured goods. These costs are identified in an economically feasible way.

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ajanarayan Te tiles td

Direct Labor Costs43

Direct Labor costs include the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way.


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Indirect Production Costs (Manufacturing Overhead)44

Manufacturing overhead includes all costs associated with the production process that the company cannot be traced to the manufactured goods in an economically feasible way.


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Income Statement Presentation of Costs for a ManufacturerThe manufacturers cost of goods produced and then sold is usually composed of the three major categories of cost: Direct materials Direct labor Indirect manufacturing14.09.2010 Rajanarayan Textiles Ltd 45

Direct versus Indirect Costs46

Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool.

Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production.

Indirect CostsRajanarayan Textiles Ltd 14.09.2010

Direct labor is a small percentage of total costs

Product-line profit margins are hard to explain Line managers do not believe the product costs reports Some products that have reported high profit margins are not sold by competitorsajanarayan extiles Ltd 7

Sales are increasing, but profits are declining.

Marketing does not use costs reports for pricing decisions. .

Suppose our production process looks like t is:

Storage Waiting TimeNVA TimeNVAVA NVA

Process Time VA

Move Inspection TimeNVA TimeNVA

= Valued-added activity Valued= Non-value-added activity Non-value-

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Our goal is to reduce or eliminate the non-value-added activities.

Storage Waiting TimeNVA TimeNVAVA NVA

Process Time VA

Move Inspection TimeNVA TimeNVA

= Valued-added activity Valued= Non-value-added activity Non-value-

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ajanara an Te tiles td

Lean Manufacturing or Kaizen Costing

Motion Over Production Transport Over Quality Work-in-process/Waiting Inventory Defects and Re-works14. . 10 Rajanara an e tiles td

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Kaizen Costing + Target Costing = Total Cost Management

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Spinning Mill Activities

Mixing Blow Room Carding Combing Drawing Roving Spinning Cone Winding Packing

Spinning Mill Resources

Raw Material Labour Power Spares Machines Money


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100s Combed Parallel Yarn ABC CostingDEPARTMENT

Rs/Kg 138.42 1.30 0.99 15.56 0.35 0.31 5.61 0.45 4.76 95.56 10.41 2.20 2.70 2.59 281.22

RAW MATERIAL-Resource MIXING BLOWROOM CARDING SLIVERLAP RIBBONLAP COMBER DRAWING-RSB SIMPLEX RINGFRAME MANUAL CONE CHEESE MANUAL CONE PACKING TOTAL -Activities


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30s cbd Knitting yarn for T Shirt Modern Machines Vs Old Machines CostSno DEPARTMENT 1MIXING 2BLOWROOM 3CARDING 4SLIVERLAP 5RIBBONLAP 6COMBER 7DRAWING 8SIMPLEX 9RINGFRAME 10CONE WINDING 11PACKING 12SALE COMMISSION 13TOTAL 1Raw Material 2 Manufacturing 3 Total cost 4 Sale price 5 Profit/Kg 6 % Low margin Rule ABC and Economic Value Analysis


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Modern RS/KG 0.45 0.97 1.43 0.15 0.15 1.14 0.43 0.87 41.29 2.69 2.15 1.75 53.48 110.00 53.48 163.48 175.00 11.52 38%

Old Mcs RS/KG 0.45 1.46 3.91 0.15 0.15 4.93 1.05 2.51 23.59 4.19 2.15 1.75 46.30 110.00 46.30 156.30 175.00 18.7054


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ACTIVITY BASED COSTING

Re-cap

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ACTIVITY-BASED COSTING (ABC)Cost Objects (e.g., products and customers)

Activities

Consumption of Resources

Cost56

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Activity-Based Costing (ABC)Activity An event that causes the consumption of overhead resources

Examples of Activities

Setting up machines14.09.2010

Admitting hospital patients

Billing customers

Opening a bank account57


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Activity-Based Costing (ABC)Activity Cost Pool Activity MeasureA cost bucket in which costs related to a particular activity are accumulated. Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs. A predetermined overhead rate for each activity cost pool.

Activity Rate


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Limitations of Activity-Based CostingCosts of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 1. Products differ substantially in volume, batch size, and in activities required. 2. Conditions have changed substantially since the existing cost system was established. 3. Overhead costs are high and increasing and no one seems to understand why. 4. Management does not trust the existing cost system and it ignores data from it when making decisions.Rajanarayan Textiles Ltd 14.09.2010



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Product Diversity62

Can you identify any problems Aerotech is likely to face as a result of this distortion?Mode I Traditional costing $ 209.00 ABC costing 183.44 Cost distortion per unit 25.56 Units produced 10,000 Total cost distortion 255,600 Mode II $ 302.00 261.81 40.19 20,000 803,800 Mode III $ 126.00 390.85 (264.85) 4,000 (1,059,400)

Traditional costing understates the cost of complex, low volume products.Rajanarayan Textiles Ltd 14.09.2010


CONCLUSIONS1.ABC

Costing is Management tool . 2.Can be better used to improve profit margin. 3.ABC Data can be used for CRM, Target Costing , Product Development , Lean Manufacturing and Six Sigma . 4.ABC can be implemented for Manufacturing , Service industries and Educational institutions. 5.More useful in diversified production industries . 6.It is must in todays environment. 7.IT ERP can be used for implementation of ABC to avoid manual error , speediness and accuracy.Rajanarayan Textiles Ltd 14.09.2010

End of ChapterRajanarayan Textiles Ltd 14.09.2010

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Activity Based Costing

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