Activity based costing

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Activity based costing

  1. 1. ACTIVITY-BASED COSTING Ankur Verma Abhinav ParmarMcGraw-Hill/Irwin Arvinderpal Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. ACTIVITY BASED COSTING Traditional costing system ABC System1. Direct and indirect costs 1. The direct and indirect costs are are allocated to process allocated to activities like centres or major departments Purchases, Material handling, Producing the goods, machine set ups, Supervising production workers, Inspecting finished goods, Dispatching good to customers2. Cost driver as base for 2.Cost driver as base for allocationallocation of overheads is not of overheads is based on causebased on cause and effect and effect relationship betweenrelationship overheads and the overhead allocation base (the cost driver) Stores deptt – Labour hours or machine hours or units produced3. There is only one cost 3. There are many allocation bases driver Or OH allocation as per activity chosen and cause and effect base relationship 1-2
  3. 3. Traditional, Volume-Based Product-Costing System• Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III.• The following information is obtained from company records: Mode I Mode II Mode III Production: Units 10,000 20,000 4,000 Runs 1 run of 10,000 4 runs of 10 runs of units 5,000 units 400 units 1-3
  4. 4. Traditional, Volume-Based Product-Costing System Additional information includes: Mode I Mode II Mode IIIDirect materials $ 50.00 $ 90.00 $ 20.00Direct labor 60.00 80.00 40.00Budgeted manufacturing overhead $3,894,000 Mode I Mode II Mode III Direct materials $ 50.00 $ 90.00 $ 20.00 Direct labor (hr/board) 3 4 2 Setup time (hr/run) 10 10 10 Machine time (hr/board) 1 1.25 2 Manufacturing overhead is determined as follows 1-4
  5. 5. Traditional, Volume-Based Product-Costing System Mode I Mode II Mode III Units produced 10,000 20,000 4,000 Direct labor (hr/unit) 3 4 2 Total hours 30,000 80,000 8,000 Total hours required 118,000Budgeted manufacturing overhead $3,894,000 = $33 per hourBudgeted direct-labor hours 118,000 Mode I Mode II Mode III Direct labor (hr/unit) 3 4 2 Overhead rate per hour $ 33 $ 33 $ 33 Overhead per unit $ 99 $ 132 $ 66 1-5
  6. 6. Traditional, Volume-Based Product-Costing SystemWith these product costs, Aerotech established target selling prices (Cost × 125%). Mode I Mode II Mode III Direct materials $ 50.00 $ 90.00 $ 20.00 Direct labor 60.00 80.00 40.00 Manufacturing overhead 99.00 132.00 66.00 Total $ 209.00 $ 302.00 $ 126.00 Mode I Mode II Mode III Cost per unit $ 209.00 $ 302.00 $ 126.00 Target selling price 261.25 377.50 157.50 209.00 x 1.25 1-6
  7. 7. Activity Based Costing System (ABC) ABC systems follow a two- stage procedure to assignoverhead costs to products. 1-7
  8. 8. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Stage One Identify significantactivities and assign overhead costs to each activity inproportion to resources used. 1-8
  9. 9. Activity Based Costing System (ABC) ABC systems follow a two-stage procedure to assign overhead costs to products. Stage Two Identify cost driversappropriate to each activity and allocate overhead to the products. 1-9
  10. 10. ABC System1. Identify major activitiesactivity consists of aggregation of tasks having common characteristics) e.g. Activity: purchase of materials : Tasks: receiving a purchase request, inviting quotations, selecting supplier, placing orders, receiving material 1-10
  11. 11. 2. Assigning costs to Activity Cost Centers:Cost incurred on these activities areassigned to these Activity Cost Centers.Direct costs are traced directly.Indirect costs are assigned to activities on thebasis of cause and effect cost drivers. 1-11
  12. 12. There must be a cause - effect relationshipbetween the overheads to be allocated and theallocation base otherwise inaccurate allocationof overheads will occur.For an example, it would be wrong to allocateoverheads of stores dept. on the basis of laborhours.It should be more appropriately based on numberof units handled or used in production process. 1-12
  13. 13. 3. Selecting cost drivers for allocating coststo cost objectsThe costs accumulated for an activity cost centreare then allocated to different cost objects.For this, a separate activity cost driver orallocation rate is used.In ABC analysis, the tracing of overheads to cost objects requires that cost behavior must be understood so that appropriate cost drivers are identified. 1-13
  14. 14. Identifying activities and cost driversdepends upon type of activity, Volume related or not volume relatedMajor activity Associated costs Cost drivers1. Processing orders for 1. Labor cost of 1. No. of purchase Purchase of materials/ employees orders processed Stores working in purchase dept.2. Handling materials and 2. Labor cost of 2. No. of materials and Parts stores, depreciation parts requisitions of machines used for moving materials3. Inspection of material and 3. Labor cost of 3. No. of receipts of parts purchased inspection team, materials and parts Depr. Of testing equipments4. Setting up production 4. Labor cost of 4. No. of set ups procedures works involved in set- ups and depr. of set up equipments 1-14
  15. 15. Identifying activities and cost driversDepends upon type of activity, Volume related or not volume relatedMajor activity Associated costs Cost drivers5. Producing the goods 5. Depreciation of 5. No. of machine hours machines6. Supervising production 6. Salary of assembly 6. No. of assemblyworkers supervisors labor hours7. Inspecting finished goods 7. Labor cost of 7. No. of inspections inspectors and depreciation of test equipments8. Dispatching good to 8. Labor cost of 8. No. of boxes packedcustomers packing and cost of Packing materials 1-15
  16. 16. Two Key PointsA large proportion of non- Product diversityunit-level activities When the consumptionA unit-level cost driver, ratios differ widelysuch as direct labor, between activities, nomachine hours, or single cost driver willthroughput, will not be accurately assign theable to assign the costs resulting overhead costs.of non-unit-level activitiesaccurately. 1-16
  17. 17. Cost DriversA characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Behavioral Correlation Effects Cost of Measurement 1-17
  18. 18. Direct versus Indirect CostsVolume-Based Costing Activity-Based Costing All production costs An effort is made to except direct account for as many materials and direct costs as possible as labor are lumped direct costs of together in one production. overhead cost pool. Indirect Costs 1-18
  19. 19. Interviewing and Paper TrailsThe information for ABC systems initially comesfrom interviews with employees in the supportdepartments and a review of each department’srecords. 1-19
  20. 20. Storyboarding A procedure used to develop a detailedprocess flow chart, which visually represents activities and the relationships among activities. Step These are the steps we 1 follow to build a Step memory board. 2 Step 3 Step 4 1-20
  21. 21. Machinery cost pool Maintenance Lubrication Depreciation ElectricityComputer Support Calibration 1-21
  22. 22. Engineering cost poolEngineering salaries Engineering softwareEngineering supplies Depreciation 1-22
  23. 23. Facility cost poolPlant depr. Property taxesPlant mgmt. InsurancePlant maint. Security 1-23
  24. 24. Overhead Costs Total budgeted cost = $3,894,000 Identification Activity of Activity must be done on Activity Cost Poolseach unit Costproduced. Pools Product- Unit Batch Sustaining Facility Level Level Level Level Machinery Setup Engineering Facility cost pool cost pool cost pool cost pool $1,212,600 $3,000 $700,000 $507,400 Activity Activities needed to support Activity required in order performed an entire product line for the production on each process to occur. batch produced. 1-24
  25. 25. Product- Unit Batch Sustaining Facility Level Level Level LevelMachinery Setup Engineering Facility cost pool cost pool cost pool cost pool$1,212,600 $3,000 $700,000 $507,400 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000 1-25
  26. 26. STAGE ONEVarious overhead Maintenance Lubrication costs related to machinery Depreciation Electricity Computer Support Calibration Activity cost Machinery Cost Pool pool Total budgeted cost = $1,212,600 1-26
  27. 27. STAGE TWOCalculate Budgeted Machinery Costs = $1,212,600the pool Budgeted Machine Hours 43,000 rate = $28.20/hour Mode I: Mode II: $28.20 per hr. $28.20 per hr. 1 hr. per unit 1.25 hr. per unit Cost $28.20 per unit $35.25 per unitAssignment Mode III: $28.20 per hr. 2 hr. per unit $56.40 per unit 1-27
  28. 28. STAGE ONE Total budgeted setup cost Calculation of $20 per hourtotal setup cost 10 hr. per setup $200 cost per setup 15 production runs $ 3,000 Total Activity cost Setup Cost Pool pool Total budgeted cost = $3,000 1-28
  29. 29. STAGE TWOCalculate Budgeted Setup Costs = $3,000the pool Planned Production Runs 15 runs rate = $200 per run Mode I: (1 Run) Mode II: (4 Runs) $200 per run $200 per run 10,000 units per run 5,000 units per run Cost = $.02 per unit = $.04 per unitAssignment Mode III: (10 Runs) $200 per run 400 units per run = $.50 per unit 1-29
  30. 30. STAGE ONEVarious overhead Engineering salaries Engineering software costs related to engineering Engineering supplies Depreciation Activity cost Engineering Cost Pool pool Total budgeted cost = $700,000 1-30
  31. 31. STAGE TWOAllocate based Engineering Cost Poolon engineering Total budgeted cost = $700,000 transactions Mode I: Mode II: 25% × $700,000 45% × $700,000 10,000 units 20,000 units Cost = $17.50 per unit = $15.75 per unit Assignment Mode III: 30% × $700,000 4,000 units = $52.50 per unit 1-31
  32. 32. Exh. STAGE ONE 5-9Various overhead Plant depr. Property taxes costs related Plant mgmt. Insurance to general operations Plant maint. Security Activity cost Facility Cost Pool pool Total budgeted cost = $507,400 1-32
  33. 33. Exh. STAGE TWO 5-9Calculate Budgeted Facilities Cost = $507,400the pool Budgeted Direct-Labor Hours 118,000 rate = $4.30/hour Mode I: Mode II: $4.30 per hr. $4.30 per hr. × 3 hr. per unit × 4 hr. per unit Cost $12.90 per unit $17.20 per unitAssignment Mode III: $4.30 per hr. × 2 hr. per unit $8.60 per unit 1-33
  34. 34. Other Overhead Costs Re c e ivin g an d In s pe c t ion Cos t P oolBoard Ove rh e ad × % ÷ Un its = Cos t/Un itMode I $ 200,000 × 6% ÷ 10,000 = $ 1.20Mode II 200,000 × 24% ÷ 20,000 = 2.40Mode III 200,000 × 70% ÷ 4,000 = 35.00 Mat e rial-Han dlin g Cos t P ool Board Ove rh e ad × % ÷ Un its = Cos t/Un it Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20 Mode II 600,000 × 30% ÷ 20,000 = 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50 Qu alit y-As s u ran c e Cos t P oolBoard Ove rh e ad × % ÷ Un its = Cos t/Un itMode I $ 421,000 × 20% ÷ 10,000 = $ 8.42Mode II 421,000 × 40% ÷ 20,000 = 8.42Mode III 421,000 × 40% ÷ 4,000 = 42.10 P ac kagin g an d Sh ippin g Cos t P ool Board Ove rh e ad × % ÷ Un its = Cos t/Un it Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00 Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25 1-34
  35. 35. Other Overhead Costs Re c e ivin g an d In s pe c t ion Cos t P oolBoard Ove rh e ad × % ÷ Un its = Cos t/Un itMode I $ 200,000 × 6% ÷ 10,000 = $ 1.20Mode II 200,000 × 24% ÷ 20,000 = 2.40Mode III 200,000 × 70% ÷ 4,000 = 35.00 Mat e rial-Han dlin g Cos t P ool Board Ove rh e ad × % ÷ Un its = Cos t/Un it $14.82 Mode I Mode II $ 600,000 600,000 × × 7% 30% ÷ ÷ 10,000 20,000 = $ = 4.20 9.00 Mode III 600,000 × 63% ÷ 4,000 = 94.50 Qu alit y-As s u ran c e Cos t P oolBoard Ove rh e ad × % ÷ Un its = Cos t/Un itMode I $ 421,000 × 20% ÷ 10,000 = $ 8.42Mode II 421,000 × 40% ÷ 20,000 = 8.42Mode III 421,000 × 40% ÷ 4,000 = 42.10 P ac kagin g an d Sh ippin g Cos t P ool Board Ove rh e ad × % ÷ Un its = Cos t/Un it Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00 Mode II 250,000 × 30% ÷ 20,000 = 3.75 Mode III 250,000 × 66% ÷ 4,000 = 41.25 1-35
  36. 36. Product Cost from ABC These are the new product costs when Aerotech uses ABC. Mode I Mode II Mode IIIDirect materials $ 50.00 $ 90.00 $ 20.00Direct labor 60.00 80.00 40.00MachinerySetupEngineeringFacilitiesOtherTotal 1-36
  37. 37. Product Cost from ABC These are the new product costs when Aerotech uses ABC. Mode I Mode II Mode IIIDirect materials $ 50.00 $ 90.00 $ 20.00Direct labor 60.00 80.00 40.00Machinery 28.20 35.25 56.40Setup 0.02 0.04 0.50Engineering 17.50 15.75 52.50Facilities 12.90 17.20 8.60Other 14.82 23.57 212.85Total $ 183.44 $ 261.81 $ 390.85 1-37
  38. 38. Distorted Product Costs Both original and ABC target selling prices are based on (Cost × 125%). Mo de I Mo de II Mo de III To t a lTra dit io n a l co s t in g $ 209.00 $ 302.00 $ 126.00ABC co s t in g 183.44 261.81 390.85u n it s 10,000 20,000 4,000 To t a l co s t sTra dit io n a lABC 1-38
  39. 39. Distorted Product CostsBoth original and ABC target selling prices are based on (Cost × 125%). Mo de I Mo de II Mo de III To t a l Tra dit io n a l co s t in g209.00 $ $ 302.00 $ 126.00 NA AB C co s t in g 183.44 261.81 390.85 n a u n it s 10,000 20,000 4,000 n a To t a l co s t s Tra dit io n a l 2,090,000 6,040,000 504,000 8634000 AB C 1834400 5236200 1563400 8634000 1-39
  40. 40. Distorted Product Costs Both original and ABC target selling prices are based on (Cost × 125%). Mo de I Mo de II Mo de IIITra dit io n a l co s t in g $ 209.00 $ 302.00 $ 126.00ABC co s t in g 183.44 261.81 390.85Origin a l t a rget s ellin g p riceABC t a rget s ellin g p rice . 1-40
  41. 41. Distorted Product Costs Both original and ABC target selling prices are based on (Cost × 125%). Mode I Mode II Mode IIITradition al cos tin g $ 209.00 $ 302.00 $ 126.00ABC cos tin g 183.44 261.81 390.85Origin al targe t s e llin g price 261.25 377.50 157.50ABC targe t s e llin g price 229.30 327.26 488.56 The selling price of Mode I and II are reduced and the selling price for Mode III is increased. [$209.00 × 1.25] [$183.44 × 1.25] 1-41
  42. 42. Distorted Product Costs Can you identify any problems Aerotech is likely to face as a result of this distortion? Mode I Mode II Mode IIITradition al cos tin g $ 209.00 $ 302.00 $ 126.00ABC cos tin g 183.44 261.81 390.85Cos t dis tortion pe r u n it 25.56 40.19 (264.85)Un its produ ce d 10,000 20,000 4,000Total cos t dis tortion 255,600 803,800 (1,059,400) Traditional costing understates the cost of complex, low volume products. 1-42
  43. 43. Indicators of Need for ABC Direct labor is a Product-line profit small percentage margins are hard of total costs to explain Line managers do not Sales are increasing, believe the productbut profits are declining. costs reports Some products that Marketing does not have reported high use costs reports for profit margins are not pricing decisions sold by competitors 1-43
  44. 44. The use of ABC costing information to help managementmake decisions 1-44
  45. 45. Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs. 1-45
  46. 46. Activities 1-46
  47. 47. Cost Assignment View Resource costs Activities Cost Objects 1-47
  48. 48. Cost Assignment View Resource costs Process View Activity Analysis Activity Evaluation Root Activity PerformanceCauses Triggers Activities Measures Cost Objects 1-48
  49. 49. Activities Nonvalue- added activitiesUnnecessary Necessary Reduce or Continually Evaluate Eliminate and Improve 1-49
  50. 50. 1. Identify Activities. 2. Identify Non-Value-Added Activities. 3. Understand Activity Linkages, Root Causes, and Triggers. Inspect ReworkSpecify Select Receive Produce finished defective parts vendor parts goods goods products 4. Establish Performance Measures. 5. Report Non-Value-Added Costs. 1-50
  51. 51. Process timeInspection time Storage time Move time Waiting time 1-51
  52. 52. Customer profitability analysis uses activity-based costing to determinethe activities, costs, and profit associated with serving particular customers. 1-52
  53. 53. Required special packaging. Orders Demand small fastquantities. service. Often Orders changes frequently. orders. A costly 1-53
  54. 54. Cost DriveCustomer-Related Activities Cost Driver Base RateOrder processing Purchase orders $ 150Sales contacts (phone calls, faxes, etc.) Contacts 100Sales visits Visits 1,000Shipment processing Shipments 200Billing and collection Invoices 160Design/engineering change orders Design changes 4,000Special packaging Units packaged 40Special handling Units handled 60 A company may use these customer related costs to help determine the profitability of each customer. 1-54
  55. 55. No materials are purchased and no products are manufactured until they are needed. The primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production. 1-55
  56. 56. Smooth, uniform production rate Pull method of production Purchase is small lot sizes Quick, inexpensive setups High quality materials Effective preventive maintenance Teamwork Multiskilled workers 1-56
  57. 57. Long-term contracts with suppliers.Only a few Parts deliveredsuppliers. in small lots. Grouped Minimalpayments to inspection of vendor. materials. 1-57
  58. 58. • Activity based costing in service industry• As useful as in mfg. industry• Mangers want more detailed and accurate information about the cost of producing products and services they are selling• Airlines, ins co, banks, hospitals, fin service firms, hotels railroads,• Air France, American express, Bank of America, DHL, Fed Ex, US postal service 1-58
  59. 59. ABC at service companies:Identifying Activities Activity cost pools Cost driversClassification of activities at• Unit level :• batch level,• product sustaining level,• facility (general operations) level 1-59
  60. 60. Bajaj Allianze General Insurance Co. LtdClaims DepartmentClassification of activities at• Unit level : Entering initial claim into computer• batch level: moving a batch of claims from one processing step to the next• product sustaining level: maintenance of the medical service provider network ( physicians, hospitals )• facility (general operations) level: general administration of claims business unit 1-60
  61. 61. • ABC at Delaware medical centre (Primary Care Unit- OPD)• Patient Appointment• New routine extended complex• Continuing routine extended complex• Every appointment needs• Regd. nurse 1 : vital signs/preparing patient for Primary health care professional• PHCP 1: physician / intern / resident doctor or nurse practitioner 1-61
  62. 62. • ABC team identified :• Activities cost driversPhysician time Physician minutes with patientPractitioner nurse time P-Nurse minutes with patientIntern or resident time Intern minutes with patientRegd. Nurse time Regd. Nurse minutes with patientClerical time: new patients New patient visitsClerical time : continuing Continuiing patient visitsBilling Billing lines (items on a bill)Facility Patient visits (both new and continuing) 1-62
  63. 63. • Activity : physician time• Cost driver : physician minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 960000 240000 4 R 80000 320000 8000 $40• E 100000 400000 5000 $80• C 60000 240000 2000 $120• Activity Nurse Practitioner time• Cost driver : NP minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 90000 30000 3 R 12000 36000 1200 $30• E 10000 30000 500 $60• C 8000 24000 320 $75 1-63
  64. 64. • Activity : intern or resident time• Cost driver : intern or resident minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 412500 125000 3.30 R 40000 132000 4000 $33• E 50000 165000 2500 $66• C 35000 115500 1000 $115• Activity : Rgd. nurse time• Cost driver : RN minutes with patient• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 281980 245200 1.15 R 132000 151800 13200 $11.50• E 80000 92000 8000 $11.50• C 33200 38180 3320 $11.50 1-64
  65. 65. • Activity : Clerical time –new patients• Cost driver : New patients number• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 135300 12300 11.00 R 7200 79200 7200 $11• E 3000 33000 3000 $11• C 2100 23100 2100 $11• Activity : Cleical time – continuing patients• Cost driver : cont. patients number• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 61100 12220 5.00 R 6000 30000 6000 $5• E 5000 25000 5000 $5• C 1220 6100 1220 $5 1-65
  66. 66. • Activity : Billing• Cost driver : Billing lines on a bill• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 38480 76960 0.50 R 26400 13200 13200 $1.00• E 24000 12000 8000 $1.50• C 26560 13280 3320 $4.00• Activity : Facility• Cost driver : number of new plus cont. patients visits• Cost cost driver rate PV driver activity no. of activity• pool qty Type qty cost visits cost /p• 245200 24520 10.00 R 13200 132000 13200 $10• E 8000 80000 8000 $10• C 3320 33200 3320 $10 1-66
  67. 67. • Costing of service• 1. Each patient sees either a physician or PN or intern or resident – not all four• 2. each patient is either a new patient or a continuing patient and not both.• 3. to compute cost of particular appointment, we should select only one of primary health care professionals, and select one of the two clerical time categories –new or continuing.• 4. finally since every appointment involves RN , billing, and use of primary care unit facility, all of these activities must be included in the cost calculation. 1-67
  68. 68. • Cost of extended appointment for a new patient seeing a nurse practitioner• Activity Cost• Nurse practitioner time• RN time• Clerical time –new patients• Billing• Facility• Total 94.00 1-68
  69. 69. • Cost of extended appointment for a new patient seeing a nurse practitioner• Activity cost• Nurse practitioner time 60.00• RN time 11.50• Clerical time –new patients 11.00• Billing 1.50• Facility 10.00• Total 94.00 1-69
  70. 70. 1-70

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