ACTIVITY BASED COSTING SYSTEM

TRADITIONAL COSTING SYSTEM

•It focused on product costing by tracing direct costs to the product and indirect costs are allocated through cost centres .

•Traditionally , indirect costs have been allocated to the end products in three steps:1. From ledger accounts to production and

service departments.2. From service departments to production

departments following reapportionment methods of allocation.

3. Finally allocating indirect costs of production departments to the products.

Patio gill company used a job order product costing system to find the cost of its three products of grill the standard STD, deluxe DEL and ultimate ULT.  STANDARD DELUXE ULTIMATEPLANNED ANNUAL PRODUCTION      

VOLUME IN UNITS 10000 8000 2000

PRODUCTION RUN80 runs of 125 units

80 runs of 100 units

40 runs of 50 units

DIRECT MATERIAL $100 $120 $180

DIRECT LABOR$180(9hours

@20)$220(11hour

s@20)$260(13hou

rs@20)MACHINE HOURS PER PRODUCT 10 12 17TOTAL MACHINE HOUR 100000 960000 340000

Product costs from traditional, volume based product costing system: Patio Grill company

 STANDAR

D DELUX

E ULTIMATE

DIRECT MATERIAL $100 $120 $180

DIRECT LABOR $180 $220 $260

MANUFACTURING OVERHEAD $216 $264 $312

TOTAL $496 $604 $752

       PREDETERMINED OVERHEAD RATE      BUDGETED MATERIAL OVERHEAD      DIRECT LABOUR BUDGETED HOURS      

STD: 10000 Units*9hours 90000    

DEL: 8000 Units*11hours 88000    

ULT: 2000 Units*13hours 26000    

TOTAL DIRECT LABOUR HOURS 204000    PREDETERMINED OVERHEAD RATE:      

$4,896,000/204,000= $24Per hour      

Trouble in patio company

• Less profitability by the prodcts• Unable to achieve target

price( 120% of full product cost) standard Deluxe Ultimate

Production cost under traditional volume based system

$496.00 $604.00 $752.00

Target selling price

$595.00 $724.80 $902.40

Actual selling price

$585.00 $705.00 $940.00

The Need for a New Approach

•Tremendous change in manufacturing and service industries.•Decrease in amount of direct labour and direct material usage.•Significant increase in total overhead costs.•Intense global competition.•Costs of non – volume related activities can not be apportioned on volume basis as in traditional method.•There was an urgent need to integrate activity measurement and financial measurement.

Defintion as per CIMA:

Cost attribution to cost units on the basis of benefit received from indirect activities such as ordering,setting up,assuring,quality.

Meaning:

Activity based costing is an accounting methodology that assigns costs to activities

rather than products or services .•Focuses on activities as the fundamental cost objects.•Costs are grouped according to what causes them to be incurred.

Characteristics :

1)It lays emphasis on different costs for different purposes and only those costs are identified which are relevant to a particular decision.2)The more important distinction between cost behaviour patterns are volume related , time related and events related.3)Cost drivers(activities those generate costs) need to be identified.4)The reporting of costs incurred on significant activities provides basis for understanding what causes overhead costs.4)Effective method of excercising cost control.5)It aims at rectifying inaccurate cost information.

Traditional v/s ABC Approach:

Traditional approach ABC approach

1)Lack of cause and effect relationship between cost allocation basis and indirect cost pools.

1)Presence of cause and effect relationship between cost allocation basis and indirect cost pools.

2)Uses a few pools of indirect costs resulting in overcosting or undercosting of products.

2)Rational basis of assigning indirect costs to various activities.

3)Wrong pricing decisions resuting in loss of market share .

3)Improved decision making such as fixing selling price and pinpointing the area where cost reduction is possible.

Cost driver

It is a characteristic of an activity of an event or activity that results in the incurrence of costs.

Factors affecting selection of cost drivers

• Degree of correlation• Cost of measurement• Behavioral effects

Activity Cost Pool:

The overhead cost attributed to a distinct type of activity. For example: ordering materials or setting up machines

Allocation of overheads under ABC:

Service departments & Factory overheads

Assigning costs ofIndividual activities

Activity cost pools

Product lines

Application of cost driver rates

Overhead costsTotal budgeted cost = $4,896,000

Activity cost pools

Machine related cost pool

$ 1,242,000

Set up cost tool$ 210,000

purchasing cost pool

$ 300,000Quality

assurance cost pool

$110,000Packing cost pool

$264,000

Engineering design cost

pool$ 130,000

Faci;itycost pool

$ 2,300,000

Compute product cost of patio grill under various activity pools

Steps involved in Activity-based costing

•Identify and classify the major activities and allocate overheads to the appropriate cost pools.•Identify the cost driver that has a strong correlation to the costs in the cost pool.

•Compute the overhead rate for each pool.

•Establish demands made by a particular product on activities using cost drivers.

•Assign overhead costs to products using the overhead rates :In assigning overhead costs, it is necessary to know the

expected use of cost drivers for each product.

ABC Data and Calculation for the machine Related cost Pool: Patio Grill company

Total Product Cost as per ABC

STD DEL ULT

DIRECT MATERIAL $100.00 $120.00 $180.00

DIRECT LABOR $180.00 @220.00 @260.00

TOTAL DIRECT COST $280.00 $340.00 $440.00

INDIRECT COST

MACHINE RELATED $54.00 $64.80 $440.00

SET UP 8.40 10.50 21.00

PURCHASING 10.00 12.00 52.00

MATERIAL HANDELING

13.60 17.00 34.00

QUALITY ASSURANCE 4.00 5.00 15.00

PACKING 12.00 12.00 24.00

ENGINEERING DESIGN

5.00 5.00 20.00

FACILITY 100.00 120.00 170.00

TOTAL INDIRECT COST

$207.00 $246.30 $427.80

TOTAL PRODUCT COST

$487.00 $586.30 $867.80

Rules developed by Kaplan and Cooper for ABC:

•Focus on expensive resources.•Emphasis on resources whose consumption varies significantly.•Focus on resources whose demand patterns are uncorrelated.

Stages of ABC

• ABC stage one -- Overhead costs are allocated to activity cost pools.

• Unit level: Performed each time a unit is produced• Batch level: Performed each time a batch is produced

rather than a unit.

•Product-sustaining level: It includes activities that are needed to support entire product line .

• Facility level [general operations level]: These activities are required in order for the entire production process to occur

ABC Stage two –

•Cost drivers are identified for each activity cost pool.•Unit activity costs for product lines and activity cost pools are computed.•The overhead costs allocated to the cost pools is assigned to products using cost

Main activities and its cost driversMain activities Cost drivers

1) Material planning • No. of material transactions•Volume of material receipts•Volume of material orders

2)Maintenance • No. of machine breakdowns•Maintenance schedule•Capital expenditure•Activity levels

3) Customer order processing

•Order value•Order source•Customer location

4)Inspection •Inspection plans•Number of problem suppliers•Lack of good quality

Comparison of ABC v/s Traditional costing system

STD DEL ULT

Reported unit overhead cost: traditional costing system activity based costing system

$216.00 207.00

$264.00 246.30

$312.00 427.80

Reported unit product cost (direct material, direct labour and overhead): traditional costing system activity based costing system

496.00 487.00

604.00 586.30

752.00 867.80

Sales price data:

Original targey price(120% of product cost based on traditional costing systemNew target price(120% of product cost based on activity based costing system

595.20

584.40

724.80

703.56

902.40

1041.36

Actual current selling price 585.00 705.00 940.00

Gaining competitiv

e advantage

Which product should we promote?

Which customers are profitable?

Which distribution channels should we follow?

How should we measure performance?

What prices should we set?

How to implement ABC?

1)Identify functional areas.2) Identify key activities in each functional area.3)Allocate common indirect costs to various activities.4)Identify most suitable cost driver in each activity under functional areas.5)Prepare statement of expenditure activity-wise.6)Compare it with value addition activity wise to know which activities need to be eliminated or need improvement.

Advantages of ABC

• More accurate • Understand how costs are actually consumed • Use of more cost pools to assign overhead costs• Enhanced control over overhead costs• Better management decisions• Improvement in performance• Product/service pricing• Make or buy decision• Transfer pricing• Determination of products service costs

Limitations of ABC

•Can be expensive to use•Does not measure incremental costs

Ways of achieving cost reduction under ABC

Ways of achieving cost reduction

ABC system

1. Reducing set up time To achieve low cost

2.Eliminating material handling activities.

To reduce cost of handling

3.Using common components

Wherever possible in order to save cost and time.

Conclusion:•In order to reduce the direct cost of the product , we can control the overheads when one has the information of cost centres.•It becomes necessary to have a costing system based on activity done.•Can not be applied if there is no clear distinction for the costs attached to various activities.•Implemented in different segments of an organisation .•Equally applied in service sectors.

Thank You!!