Copy of activity-based-costing

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Activity based costing

By

Prof. Augustin Amaladas


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Meaning

Activity-based costing (ABC), a strategythat gives you insight into the true cost ofindividual financial activities.

. Break down your cost managementprocess into transactions and then assigna value to each activity with our ABC

solution: BusinessObjects ActivityAnalysis


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, Activity Analysis provides clear insightinto customer, product, and channelprofitability, and is a core component of

enterprise performance management(EPM). The ability of Activity Analysis toaccurately determine costs also aids in the

costing and cross-charging of sharedservices like IT, HR, and finance.


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Historical development

Traditionally cost accountants had arbitrarily added a broadpercentage of expenses onto the direct costs to allow for the indirectcosts.

However as the percentages of indirect or overhead costs had risen,this technique became increasingly inaccurate because the indirectcosts were not caused equally by all the products. For example, oneproduct might take more time in one expensive machine thananother product, but since the amount of direct labor and materialsmight be the same, the additional cost for the use of the machinewould not be recognised when the same broad 'on-cost' percentageis added to all products. Consequently, when multiple productsshare common costs, there is a danger of one product subsidizing

another.
http://en.wikipedia.org/wiki/Accountanthttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Accountant


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The concepts of ABC were developed inthe manufacturing sector of the UnitedStates during the 1970s and 1980s.

During this time, the Consortium forAdvanced Manufacturing-International,now known simply as CAM-I, provided aformative role for studying and formalizing

the principles that have become moreformally known as Activity-BasedCosting.[1]
http://en.wikipedia.org/wiki/Manufacturing_sectorhttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/wiki/Activity-based_costinghttp://en.wikipedia.org/wiki/Activity-based_costinghttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/wiki/Manufacturing_sector


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Cooper and Kaplan described ABC as anapproach to solve the problems oftraditional cost management systems.

These traditional costing systems areoften unable to determine accurately theactual costs of production and of the costsof related services. Consequently

managers were making decisions basedon inaccurate data especially where thereare multiple products.
http://en.wikipedia.org/wiki/Cost_managementhttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Cost_management


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Instead of using broad arbitrarypercentages to allocate costs, ABC seeksto identify cause and effect relationships to

objectively assign costs


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. Costs of the activities have been identified,

the cost of each activity is attributed to eachproduct to the extent that the product uses the

activity. ABC often identifies areas of high overhead

costs per unit and so directs attention to findingways to reduce the costs or to charge more forcostly products.


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History

[2] They initially focused on manufacturingindustry where increasing technology andproductivity improvements have reduced

the relative proportion of the direct costs oflabor and materials, but have increasedrelative proportion of indirect costs. Forexample, increased automation has

reduced labor, which is a direct cost, buthas increased depreciation, which is anindirect cost.
http://en.wikipedia.org/wiki/Activity-based_costinghttp://en.wikipedia.org/wiki/Activity-based_costing


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Like manufacturing industries, financialinstitutions also have diverse products andcustomers which can cause cross-product cross-customer subsidies. Since personnel expensesrepresent the largest single component of non-interest expense in financial institutions, thesecosts must also be attributed more accurately toproducts and customers. Activity based costing,

even though originally developed formanufacturing, may even be a more useful toolfor doing this
http://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institution


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Methodology

Cost center

Cost allocation

Fixed cost Variable cost

Cost driver
http://en.wikipedia.org/wiki/Cost_centerhttp://en.wikipedia.org/w/index.php?title=Cost_allocation&action=edithttp://en.wikipedia.org/wiki/Fixed_costhttp://en.wikipedia.org/wiki/Variable_costhttp://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Variable_costhttp://en.wikipedia.org/wiki/Fixed_costhttp://en.wikipedia.org/w/index.php?title=Cost_allocation&action=edithttp://en.wikipedia.org/wiki/Cost_center


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Direct labor and materials are relatively easy to tracedirectly to products, but it is more difficult to directlyallocate indirect costs to products. Where products usecommon resources differently, some sort of weighting is

needed in the cost allocation process. The measure ofthe use of a shared activity by each of the products isknown as the cost driver. For example, the cost of theactivity of bank tellers can be ascribed to each productby measuring how long each product's transactions

takes at the counter and then by measuring the numberof each type of transaction.
http://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driver


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Limitations

Even in activity-based costing, some overheadcosts are difficult to assign to products and

customers, for example the chief executive'ssalary. These costs are termed 'businesssustaining' and are not assigned to products andcustomers because there is no meaningfulmethod. This lump of unallocated overheadcosts must nevertheless be met by contributionsfrom each of the products, but it is not as largeas the overhead costs before ABC is employed


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The Four Steps to ABC Implementation

1. Identify activitiesperform an in-depthanalysis of the operating processes ofeach responsibility segment. Each

process may consist of one or moreactivities required by outputs.


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Assign resource costs to activitiesthis is sometimes called"tracing." Traceability refers to tracing costs to cost objects todetermine why costs were incurred. DoD categorizes costs inthree ways:

Directcosts that can be traced directly to one output. Example: thematerial costs (varnish, wood, paint) to build a chair.

Indirect

costs that cannot be allocated to an individual output; inother words, they benefit two or more outputs, but not all outputs.Examples: maintenance costs for the saws that cut the wood, storagecosts, other construction materials, and quality assurance.)

General & Administrativecosts that cannot reasonably beassociated with any particular product or service produced(overhead). These costs would remain the same no matter whatoutput the activity produced. Examples: salaries of personnel inpurchasing department, depreciation on equipment, and plantsecurity.


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Identify outputsidentify all of theoutputs for which an activity segmentperforms activities and consumes

resources. Outputs can be products,services, or customers (persons or entitiesto whom a federal agency is required to

provide goods or services


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Assign activity costs to outputsassignactivity costs to outputs using activitydrivers. Activity drivers assign activity

costs to outputs based on individualoutputs consumption or demand foractivities. For example, a driver may bethe number of times an activity is

performed (transaction driver) or thelength of time an activity is performed(duration driver).


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Activity-Based Costing encouragesmanagers to identify which activities arevalue-addedthose that will best

accomplish a mission, deliver a service, ormeet a customer demand. It improvesoperational efficiency and enhances

decision-making through better, moremeaningful cost information.


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Exercise 16(Activity Based costing) A company produces four products P,Q,R and S. The data relating

to production activity are as under:

Product Qty.ofproduction

Materialcost/unit

Directlabour/unit

Machinehours/unit

Directlabourcost/unit

P

QR

S

500

5,000600

7000

5

516

17

1/2

1/22

1-1/5

0.50

0.501.00

1-1/5

3

312

9

Production overheads are as under:i) Overheads applicable to machine oriented activity-37,424

ii)Overhead relating to ordering materials-Rs.1920iii) Setup Costs-Rs.4355

iV) Administration overheads for spare parts: Rs.8600

v) Materials handling costs-7580

Th f ll i f th i f ti h b


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The following further information have beencompiled:

Product No.of setup No. of

materialsorder

No.of times

materialshandled

No.of

spareparts

PQR

S

1

6

2

8

1

4

1

4

2

10

3

12

2

5

1

4

Required:1) Select a suitable cost driver for each item of overhead expenses andcalculate the cost per unit of cost driver

2.Using the concept of activity based costing , compute the factory cost per unitOf each product.

These overhead costs are observed by products on a machine hour rate ofRs.4.80 per hour having an overhead cost per product of:

A=Rs.1.20, B=Rs.1.20, C=4.8 D=Rs.7.2


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Answer for 16

Factory overhead applicable to machine orientedactivity=Rs.37,424

Total machine Hours=Volume *Machine hour requiredfor each period=(500*1/4)+(5,000*1/4)+(600*1)+(7,000*1.5)=12,475 hrs.

Machine overhead charged =37,424/12,475 hrs=Rs.3per hour

Set up costs=4355/17(ie., total number of setups)=Rs.256.18

Material ordering cost=1920/10 operations=Rs.192

Material handling cost=7580/27 operations=Rs.280.74

Spare parts=8600/12 parts=716.67


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Answer-16.

Overhead items A B C D

Machine overhead

Setup cost

Material

Ordering cost

Material handling cost

Spare parts cost

*Rs.3=.0.75

1*256.18/500=0.51

1*192/500=

0.382*280.74/

500=1.12

2*716.67/500=

2.87

*3=0.75

6*256.18/

5000=0.31

4*192/5000

=0.1510*280.7/

5000=0.56

5*716.67/

5000=0.72

1*.3=Rs.3

2*256.18/

600=0.85

1*92/600=

0.32

3*280.74/

600=1.40

1*716.67/

600=1.19

3/2*3=4.5

8*256.18/7000=0.29

4*192/

7000=0.1112*280.74/7000=0.48

4*716.67/

7000=0.41


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duct Machine

overheads Materialordering

Mater

ialhandling

Spare

Parts

Total

(ABCsystems)

Total

(oldsystem)

difference

0.75

0.75

3.00

4.50

0.38

0.15

0.32

0.11

1.12

0.56

1.40

0.48

2.87

0.72

1.19

0.41

5.63

2.49

6.76

5.79

1.20

1.20

4.80

7.20

+4.43

+1.29

+1.96

-1.41

traditional system does not make correctassumptions that all overheads are

Related to volume and machine time.Under traditional system products A and C are

under costed because it misallocates costs for small volume products.

Set upsRs.

0.510.310.850.29


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Answer-Activity costing

The activity based costing recognises the amount of input to eachcost unit.

Product B previously avoided its full share of overhead because ofits

low machine time and may still do so if part of Rs. 37,425 ofmachine oriented

overhead should be apportioned on some other basis. Product D is over costed because the additional system loaded it

with Other attributable to activities concerned with products A,B and C as result of using a volumebased and machine oriented rate which

failed to Pay proper attention to activity costing.


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Activity costing-Exercise-2 A Company manufactures several products of varying levels of

designs and models . It uses a single overhead recovery rate based

on direct labour hours. The overheads incurred by the company inthe first half of the year are as under.

Machine operating expenses 10,12,500

Machine maintenance expenses 1,87,500

Salaries to technical staff 6,37,500

Wages and salaries of stores staff 2,62,500

During the period, the company introduced activity based costingsystem and the following significant activities were identified:

- receiving materials and components - setup of machines for production runs

- Quality inspection.


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It is also determined that :

-The machine operation and machine maintenance expensesshould be apportioned between stores and production activity in20:80 ratio.

The technical staff salaries should be apportioned between machinemaintenance, set up and quality inspection in 30:40:30 ratio.

The consumption of activities during the period under review are asunder:

Direct labour hours worked 40,000

Direct wages rate Rs. 6 per hour 2040 Material and component consignments received from suppliers

1960

Number of quality inspections carried out 1280


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The data relating to two products manufactured by the companyduring the period are as under:

Product P Product Q

Direct material costs Rs.6000 Rs.4000 Direct labour hours 960 100

Direct material consignment received 48 52

Production runs 36 24

Number of quality inspection done 30 10

Quantity produced 15,000 5,000

A potential customer has approached the company for the supply of24,000 units of a component K to be delivered in lots of 3,000 unitsper quarter. The job will involve an initial design cost of Rs. 60,000and the manufacture will involve the following per quarter.

Direct material cost - Rs.12,000; Direct labour hours - 300; Productionruns- 6; Inspections- 24; Number of consignments of direct materialsto be received -20


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The company desires to mark up of 20% on cost.

Required:

1. Calculate the cost of products P and Q based on the existing

system of single overhead recovery rate. 2. Determine the cost of products P and Q using activity based

costing system.

3. Compute the sales value per quarter of component K usingactivity based costing system.


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Answer Working notes:

1. Overhead rate=21,00,000/4000 hours=Rs.52.50 2. Apportionment of technical staff salaries:

Machine maintenance, Set up and Quality Inspection respectively=6,37,500* 30:40:30/100

= 1,91,250; 255,000and 1,91,250.

3. Rate per Cost driver:

Store receiving =275.89 Set-up production run = 670.59

Quality Inspection= 149.41

4. Single overhead recovery rate : Cost per Unit P=4.144: Q=1.97

5.Store receiving= 5,40,750:set-up production run=13,68,000

6. Rate per activity 5,40,750/1960=275.89; 13,68,000/2040=670.59;1,91,250/1280=149.41 for store receiving, setup and quality inspectionrespectively.

P and Q as per activity based costing system


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Particulars P Q

Units

Direct materials cost

Direct labour cost

Receiving /sores cost(48*275.89)(52*275.89)

Production runs/set up cost (36* 670.59)

(24*670.59)

Inspection cost (30* 149.41)

(10* 149.41)Total cost of products

Cost per unit

15000

6000

5760

13243

24141

4482

53626

3.58

5000

4000

600

14346

16094

1494

36534

7.31


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Computation of sales value per quarter of component K(Activitity basedcosting)

Particulars K

Units

Components of initial design(Rs.60000/8)

Direct materials cost

Direct labour cost (300 hours 8 Rs.6)Receiving /sores cost(20*275.89))

Production runs/set up cost (6* 670.59)

Inspection cost (24* 149.41)

Total cost of products

Add: Mark up( 25% of cost)Sales value

Selling price per unit of K(43035/3000units)

3000

7500

12000

18005518

4024

3586

34428

860743035

14.34


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Life cycle costing

Life cycle cost analysis became popularin the 1960s when the concept was takenup by U.S. government agencies as an

instrument to improve the costeffectiveness of equipment procurement.From that point, the concept has spread to

the business sector, and is used there innew product development studies, projectevaluations and management accounting.
http://en.wikipedia.org/wiki/New_product_developmenthttp://en.wikipedia.org/wiki/Projecthttp://en.wikipedia.org/wiki/Management_accountinghttp://en.wikipedia.org/wiki/Management_accountinghttp://en.wikipedia.org/wiki/Projecthttp://en.wikipedia.org/wiki/New_product_development


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Realization of a life cycle costanalysis

A life cycle cost analysis calculates thecost of a system or product over its entirelife span. This also involves the process ofProduct Life Cycle Management so thatthe life cycle profits are maximised.
http://en.wikipedia.org/wiki/Costhttp://en.wikipedia.org/wiki/Systemhttp://en.wikipedia.org/wiki/Product_%28business%29http://en.wikipedia.org/wiki/Product_Life_Cycle_Managementhttp://en.wikipedia.org/wiki/Product_Life_Cycle_Managementhttp://en.wikipedia.org/wiki/Product_%28business%29http://en.wikipedia.org/wiki/Systemhttp://en.wikipedia.org/wiki/Cost


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"cradle-to-grave analysis", or"Womb-to-Tomb

The analysis of a typical system could include costs for:

planning,

research and development,

production,

operation,

maintenance,

Cost of replacement,

disposal or salvage.

This cost analysis depends on values calculated fromother reliability analyses like failure rate, cost of spares,repair times, and component costs.
http://en.wikipedia.org/wiki/Planhttp://en.wikipedia.org/wiki/Research_and_developmenthttp://en.wikipedia.org/wiki/Production%2C_costs%2C_and_pricinghttp://en.wikipedia.org/wiki/Operationhttp://en.wikipedia.org/wiki/Repair_and_maintenancehttp://en.wikipedia.org/wiki/Replacement_valuehttp://en.wikipedia.org/wiki/Salvagehttp://en.wikipedia.org/wiki/Failure_ratehttp://en.wikipedia.org/wiki/Mean_time_to_recoveryhttp://en.wikipedia.org/wiki/Mean_time_to_recoveryhttp://en.wikipedia.org/wiki/Failure_ratehttp://en.wikipedia.org/wiki/Salvagehttp://en.wikipedia.org/wiki/Replacement_valuehttp://en.wikipedia.org/wiki/Repair_and_maintenancehttp://en.wikipedia.org/wiki/Operationhttp://en.wikipedia.org/wiki/Production%2C_costs%2C_and_pricinghttp://en.wikipedia.org/wiki/Research_and_developmenthttp://en.wikipedia.org/wiki/Plan


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A life cycle cost analysis is important forcost accounting purposes. In deciding toproduce or purchase a product or service,

a timetable of life cycle costs helps showwhat costs need to be allocated to aproduct so that an organization can

recover its costs. If all costs can not berecovered, it would not be wise to producethe product or service.
http://en.wikipedia.org/wiki/Cost_accountinghttp://en.wikipedia.org/wiki/Product_%28business%29http://en.wikipedia.org/wiki/Service_%28economics%29http://en.wikipedia.org/wiki/Timetablehttp://en.wikipedia.org/wiki/Timetablehttp://en.wikipedia.org/wiki/Service_%28economics%29http://en.wikipedia.org/wiki/Product_%28business%29http://en.wikipedia.org/wiki/Cost_accounting


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It offers three important benefits:- All costs associated with aproject/product become visible, especially:

upstream, R&D; downstream, customerservice.- It allows an analysis of business functioninterrelationships. Low R&D costs may

lead to high customer service costs in thefuture.


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- Differences in early stage expenditureare highlighted, enabling managers todevelop accurate revenue predictions.

A typical quantitative analysis wouldinvolve the use of a statement where aneasy comparison of costs can be seen by

having the different products a companyproduces next to each other.

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