Activity-Based Costing

Phuong Nguyen – Kim Tran – Amal Alqadi – Justine Laporte

Table of content

Purposes of Cost Allocation

Traditional Costing System Product cost and period cost Usage CriticismsActivity-Based Costing System Definition Comparison Steps Benefits and LimitationsApplication in GM

Purposes of Cost Allocation

Traditional Costing Systems

Product Costs Direct labor Direct materials Factory Overhead

Period Costs Administrative expense Sales expense

Appear on the income statement when goods are sold, prior to that time they are stored on the balance sheet as inventory.

Appear on the income statement in the period incurred.

Easy to trace to products

The problem comes with factory overhead

Traditional Costing SystemsTraditional Costing Systems

Typically used one rate to allocate overhead to products.

This rate was often based on direct labor dollars or direct labor hours.

This made sense, as direct labor was a major cost driver in early manufacturing plants.

Criticisms of Traditional AllocationCriticisms of Traditional Allocation

Assumes all overhead is volume-related

Factory-wide or departmental rates All related to single activity measure

Departmental focus, not process focus

Focus on costs incurred, not cause of costs

Over-costing or under-costing Complex products are not allocated an adequate

amount of overhead costs. Simple products get too much.

Today’s Manufacturing PlantsToday’s Manufacturing Plants

More complex; Often make more than one product

Often automated Use proportionately smaller amount of direct

labor making direct labor a poor allocation base for factory overhead

Multiple allocation bases should be used to allocate overhead expense

In such situations, managers need to consider using activity based costing (ABC)

ABC DefinitionsABC Definitions

Activity based costing is an approach for allocating overhead costs.

An activity is an event that incurs costs.

A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed.

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Comparison with Traditional Comparison with Traditional allocationallocation

Traditional allocation method

Activity-based allocation method

Costs

Products

Costs

Products

Activities

First stage Second stage

Example

ABC Steps

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.

Examples of Associated Costs

1. Various labor costs.

2. Depreciation.

Examples of Cost DriversExamples 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.

Level of costsLevel of costs

Activity Based ManagementActivity Based ManagementActivity-based management (ABM) is a method

of activities analysis, which is the process of studying activities to classify them and to devise way of minimizing or eliminating non-value added activities

Activity-based management focuses on managing activities to reduce costs and improve customer value.

Activity based Management

ApplicationApplication

When do we use ABC?

• The manufacturing process or number of products has changed significantly—for example, from labor intensive to capital intensive automation.

• Production or marketing managers are ignoring data provided by the existing system and are instead using “bootleg” costing data or other alternative data when pricing or making other product decisions.

ABC Was Generally Worth It…But Not Always

ABC as a GM policy (1986-1993)

Started developing ABC in 1986, GM has fully implemented ABC as a statistical analysis system for product costing since 1993.

Successfully developed & implemented in Pontiac plant in 1987

In 1989, ABC system was applied in additional 11 sites and search for the ability to implement ABC system in other 22 plans

In 1990, GM decided to implement ABC system in every plants, COF of GM was named « corporate ABC champion »

6 stages of ABC system at GM

Initiation – feasibility analysis is done (1986)

Adoption (1987)– decision to invest some level of resources is made

Adaptation (1990) – analysis is made of firm’s activities and cost drivers, ABC information is available but not yet used by non-accounting staff for decision-making ?

Acceptance(1991) – occasionally used by upper management AS AN INPUT for decision-making, but still considered a project or model

Routinization – commonly used by upper management for decision-making and considered a normal part of the information system, astablishing a net-work ABC user in GM.

Infusion/integration – used extensively and fully integrated within the primary financial system

How ABC helps GM in making profits

Helps GM to find the most profitable assets in company, including customers, investments and products.

Drives GM efficient decision making in manufacturing more profitable products and stopping unprofitable ones.

It will enable GM to be more cost effective and run the business more efficiently.

Reduce expenditures by eliminating un-value-added process

ABC system creates a competitive advantage for GM

Advantages of ABC system

Identifying and eliminating waste and non-value added activities

Easy to identify where high (and low) costs are being incurred and the cause.

Helps companies figure out ways to raise profits without raising prices

More accurate costing of products/services, customers, distribution channels.

A valuable tool for both business and process improvement.

Helps with future product planning by allocating resources effectively

Integrates well with continuous improvement programs (Six Sigma, Kaizen, Just-in time, Total Quality Management...), A valuable tool for both business and process improvement

Limitations of ABC system

ABC reports do not conform to generally accepted accounting principles (GAAP)

Complex, time consuming, and costly to collect data

Cost of buying, implementing and maintaining activity based system

May provide too much detail – obscuring the bigger picture

Conclusion

ABC was developed in 1988 as a solution to the inadequacy of traditional system, however, there are many limitations in ABC system that lead to further research and result in the development of lean accounting methods such as Balanced Scorecards and Economic Value Added (EVA) which is less complex and costly than ABC system

Reference

l http://maaw.info/ArticleSummaries/ArtSumAnderson95.htm

l http://www.questia.com/googleScholar.qst?docId=5001658502

l http://en.wikipedia.org/wiki/List_of_GM_transmissions

l http://www.questia.com/googleScholar.qst?docId=5000488038

l http://deepblue.lib.umich.edu/bitstream/2027.42/35357/2/b1784201.0001.001.pdf