Activity Based Costing

Presented ByA.L.C.S. Sudheer

L. NareshS.S. Rao

R. AvinashK. Namrata

Characteristics of ABC

Contents

Introduction

What is ABC?

Categories of ABC

Implementation of ABC

Benefits & Conclusion

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• 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.

What is ABC?

BASEDACTIVIT

YCOSTIN

G

Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.

Activity

• Traditionally cost accountants added a broad percentage of analysis into indirect costs

• The percentages of indirect and overhead costs rose as indirect costs were not caused equally by all products

• Moreover, when multiple products share common costs, there is a danger of one product subsidizing another

Historical development

Traditional Costing Methods.....

• 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

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Activity-Based Costing• Traditional allocation method

• Activity-based allocation method

Costs

Products

Costs

ProductsActivities

First stage Second stage

Need for a New System

• Amount of direct labor used in many industries has decreased

• Total overhead from depreciation on equipment, utilities, repairs, maintenance has increased

Today’s Complex Business Environment

Product Life Cycle

Use of Advanced Technology

Product Complexity

Channels of Distribution

Quality Requirements

Product Diversity

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100

1 2 3 4

Composition of Cost

Direct Material Labour Overheads

Activities and Related Cost Drivers

• Calculate unit cost• Identify activities• Identify cost driver• Compute overhead rate• Assign overhead costs

Activity-Based Costing (ABC)

• What activities are being performed by the organizational resources?

• How much does it cost to perform activities?

• Why does the organization need to perform those activities?

• How much of each activity is required for the organization's products, services, and customers?

ABC systems addresses the following Questions:

• Simple traditional difference between fixed cost and variable cost

• Appropriate distinction between cost behavior patterns and volume related, diversity related, events related and time related

• Cost drivers need to be identified

COST DRIVER:Structural determinant of cost related activity

Characteristics of ABC

Three key areas of ABC:• Product cost differentiation• Activities and their cost drivers• Identification of non-value added cost

How to develop an ABC system?

SHORT-TERM LONG-TERM

Product Value Value addition

Pricing Corporate growth

Unit level activities

Batch level activities

Product level activities

Facility level activities

Categories of ABC

Allocation of Overheads

Service Dept. & Factory overheads

Assigning costs of Individual activities

Activity Cost Pools

Product lines

Application of cost driver rates

Steps to develop ABC

Identify resources

Identify activities

Identify cost

objects

Define activity drivers

Establish demands

made

Trace cost of

activities

• Identifying the functional area

• Identifying key activities involved in each functional area

• Allocating the common indirect costs to various activities in each functional area

Implementing ABC

• Identifying the most suitable cost driver in each activity under functional area for better allocation of Indirect costs to get accurate cost information

• Prepare the statement of expenditure activity-wise and comparing it with the value addition activity-wise to know the activities which are to be eliminated or need improvement for better performance of organization.

Continued..

• Material management• Stores Management• Production Management• Quality Control

Management• Personnel Management• Sales Management• Repairs and Maintenance• Administration• Public Relations

Functional areas

Ways of achieving cost reductionWays of achieving Cost Reduction

Conventional Cost System

Activity Based Cost System

Reducing set-up time Ignore or reduce direct labor

Reduce set up time to achieve

low cost

Eliminating material handling activities

Ignore or reduce direct labor

Eliminate activities to

reduce the cost of handling

Choosing an insertion process

Pick alternative with lowest unit level activities

Pick lowest cost alternative

Using common components

Using common components to achieve cost

savings; Using non-components creates no costly

penalty

Use common components

wherever possible

• Cost management and Downsizing

• Determination of Product Service Costs

• Improvements in Performance

• Product/Service Pricing

• Make or Buy Decision

• Transfer Pricing

Benefits of implementing ABC

Gaining Competitive Advantage

Gaining Competitive Advantage

Which product to promote?Analyze profit contribution & impact

What prices should we

set?

How should we measure performance?

Which customers are profitable & why?

Which distribution channels should we follow?

How ABC system supports Corporate Strategy?

• Effective and accurate• Redesigning the product• Changing the system of evaluation of new process technologies

• Report on resource spending• Improving activities• Cost drivers rate• Accurate feedback• Provides accurate information of product cost