Activity based costing


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Activity based costing

  1. 1. Better Costing for Better Decisions Wali Memon 1
  2. 2. Indirect CostsNot easily and conveniently traceable to cost objects Cost element is shared among cost objects Physically impossible to trace Not cost effective to trace Wali Memon 2
  3. 3. Indirect CostsNeed for allocation Estimate product or activity cost What does it really cost? Increase awareness of indirect costs Activities are not free Plan more cost efficient operations Now that we know what it costs, what should we do? Wali Memon 3
  4. 4. Allocation of Indirect CostsTypical allocation methods Ability to bear Fairness or equity Benefits received Cause and effect Wali Memon 4
  5. 5. Traditional Allocation MethodIndirect costs allocated to cost object based on thecost object’s consumption of some measure ofactivity, usually labor hours $10,000,000 total indirect cost = $25 per hour rate 400,000 total labor hoursA product consuming 6 labor hours would be charged$150 of indirect costs Wali Memon 5
  6. 6. Criticisms of Traditional Overhead AllocationAssumes all overhead is volume-relatedFactory-wide or departmental rates All related to single activity measureDepartmental focus, not process focusFocus on costs incurred, not cause of costs Wali Memon 6
  7. 7. Activity-Based CostingPurpose Allocation of indirect costs based on causal activities Attempts to identify “direct” link between cost and cost object Results in better allocation Does not provide “true” cost Wali Memon 7
  8. 8. Activity-Based CostingTraditional allocation methodCosts ProductsActivity-based allocation methodCosts Activities Products First stage Second stage Wali Memon 8
  9. 9. Overview of ABCIdentifies activities required to produce the productor serviceDetermines the cost of the activitiesAllocates costs to the cost object based on the object’sconsumption of activities Wali Memon 9
  10. 10. Levels of Cost IncurrenceNot all costs are volume-related Unit level Batch level Product level Facility level Wali Memon 10
  11. 11. Operation of an ABC SystemAssign costs to activity pools First stage allocation Identify the costs incurred to perform various activitiesDetermine the measure of activity best relatedto each cost pool Cost drivers Wali Memon 11
  12. 12. Operation of an ABC SystemDetermine rate per unit of activityAssign costs to products/services based onconsumption of activities Second stage allocationIndirect costs are converted to direct costs Wali Memon 12
  13. 13. Implementing ABCStep 1 – Plan the system What are the goals? Inventory valuation Process improvement Foster active involvement Assemble cross-functional team Functional specialists Wali Memon 13
  14. 14. Implementing ABCStep 2 – Define, analyze activities and resources Decompose organization into elemental activities Who does what, and why? Interview employees Determine resources Determine inputs and outputs Wali Memon 14
  15. 15. Implementing ABCGather statistics on activities Inputs and outputs Transaction, duration, intensity For possible use as second-stage cost drivers Wali Memon 15
  16. 16. Implementing ABCStep 3 – Establish activity cost pools anddetermine first stage allocation First stage allocations assign costs to cost pools Requires costs to be re-categorized according to why they are incurred, not by type Drivers may be employee time, square footage, etc. Wali Memon 16
  17. 17. Implementing ABCStep 4 – Determine second stage drivers and assigncosts to cost objects Outputs of activity analysis may be second stage drivers Distance moved, times handled, machine hours, units, etc. Amount assigned to the cost object is the amount of activity consumed times the rate per unit of the activity Wali Memon 17
  18. 18. When is ABC Most Useful?High amounts of overhead costMultiple productsComplex productsComplex production systemSignificant variation in volume between high andlow volume products Wali Memon 18
  19. 19. When is ABC Most Useful?Different products place different demands onresourcesProblems with current cost allocations due tochanges in products or processesBetter cost information is needed Wali Memon 19
  20. 20. Activity-Based ManagementNatural extension of ABC Why are activities performed? Are they necessary? Are they consistent with organizational goals? How are they performed? Are they performed efficiently? Can they be redesigned or eliminated? Wali Memon 20
  21. 21. ABM for Process ImprovementFocus on problems, opportunitiesPrioritize opportunities for improvement Most critical Greatest potential for cost savings Wali Memon 21
  22. 22. ABM for Process ImprovementDetermine and explain causes for problems andopportunities Cannot improve the system without first understanding itSelect specific improvement projects Wali Memon 22
  23. 23. ABM for Process ImprovementUse ABC/ABM data to test potential impact ofchangesMake changesIterate Process of continual improvement Wali Memon 23
  24. 24. Implications of ABC/ABMShifts focus from managing costs to managingactivitiesAids in recognizing, measuring and controllingcomplexityPromotes understanding of why costs areincurredProvides better cost allocation information Wali Memon 24
  25. 25. Implications of ABC/ABMUseful for planning future operationsFosters continuous improvementLikely to meet with substantial resistance Analysis of why and how activities are performed Wali Memon 25