Activity based costing & activity based management
ACTIVITY BASEDCOSTING AND ACTIVITYBASED MANAGEMENT IN COMPETITIVE ERA SUBMITTED BY: PIYUSH GAUR (35)
Product Costs Direct labor and direct materials are easy to Direct labor trace to products. Direct materials The problem comes with factory Factory Overhead overhead. Period Costs Administrative expense Sales expense
Typically used one rate to allocate overhead to products. This rate was often based on direct labor hours. This made sense, as direct labor was a major cost driver in early manufacturing plants.
Manufacturing processes and the products they produce are now more complex. This results in over-costing or under-costing. Complex products are not allocated an adequate amount of overhead costs. Simple products get too much.
Then multiple allocation bases should be used to allocate overhead expense. In such situations, managers need to consider using activity based costing (ABC).
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.
Machine hours Direct labor hours Number of setups Number of products Number of purchase orders Number of employees Number of square feet
Assume that a company makes widgets Management decides to install an ABC systemOverhead Cost Drivers are Determined: Management decides that all overhead costs only have three cost drivers. Direct labor hours Machine hours Number of purchase orders
Direct Labor General LedgerPayroll taxes `1,000 `1,0 0 0 2,0 0 0Machine ` 500 1,500maintenancePurchasing Dept. `4,000 `4 0 ,50labor benefitsFringe `2,000 Machine HoursPurchasing Dept. `250SuppliesEquipment `750depreciationElectricity `1,250 No.of Purchase OrdersUnemployment `1,500insurance Overhead driver by direct labor hours
Lets assume the company makes two products, Widget A and Widget B: Let’s also assume that each product uses the following quantity of overhead cost drivers:Base Widget A Widget B TotalDirect labor hours 400 600 1,000Machine hours 100 150 250Purchase orders 50 50 100 The ABC rates are: `4,500/1,000 = `4.50 per direct labor hour `2,500/250 = `10 per machine hour `4,250/100 = `42.50 per purchase order
Widget A Base ` Rate ` Allocated Direct labor hours 400 4.50 1,800.00 Machine hours 100 10.00 1,000.00 Purchase orders 50 42.50 2,125.00 Total 4,925.00 Widget B Base ` Rate ` Allocated Direct labor hours 600 4.50 2,700.00 Machine hours 150 10.00 1,500.00 Purchase orders 50 42.50 2,125.00 Total 6,325.00The original overhead to be applied was 4,500 of direct labor driven overhead + 2,500 ofmachine hour driven overhead + 4,250 of purchase order driven overhead =` 11,250.The actual overhead allocated was 4,925 for Widget A + 6,325 for Widget B = ` 11,250
General Ledger Amt. in `Payroll taxes 1,000 This the total overhead we wereMachine 500 given, the totalmaintenancePurchasing Dept. 4,000 amount is `11,250labor as explained onFringe benefits 2,000 the previous slide.Purchasing Dept. 250Supplies Total direct laborEquipment 750 hours are 1,000, alsodepreciation given earlier.Electricity 1,250Unemployment 1,500insuranceBase Widget A Widget B TotalDirect labor hours 400 600 1,000Machine hours 100 150 250Purchase orders 40 60 100
T r t w d be: he ae oul OHR t = ae Ov hea DirectLa Hour er d/ bor s `11,2501,0 0= `11.25 perhour / 0 . A ying ov hea using t r t ppl er d his ae: WidgetA 4 0hour x `11.25 = : 0 s `4 0 ,50 W idgetB: 60 hour x `11.25 = `6,750 0 s T a ov hea a ied = `11,250 ot l er d ppl
W A idget W B idget Ta ot lTa iona M hod r dit l et `4 0 ,50 `6,750 `11,250A iv yBa Cost ct it sed ing `4,925 `6,325 `11,250Difference - 25 `4 `425 -- 0 Which is more accurate? ABC Costing! Note these are total costs. To get per-unit costs we would divide by the number of units produced.
• Product lines differ in volume and manufacturing complexity.• Product lines are numerous and diverse, and they require different degrees of support services.• Overhead costs constitute a significant portion of total costs.• The manufacturing process or number of products has changed significantly—for example, from labor intensive to capital intensive automation.
Step 1 – Plan the system What are the goals? Inventoryvaluation Process improvement Foster active involvement Assemble cross-functional team Functional specialists 18
Step 2 – Define, analyze activities and resources Decompose organization into elemental activities Who does what, and why? Interview employees Determine resources Determine inputs and outputs Gather statistics on activities Inputs and outputs Transaction, duration, intensity For possible use as second-stage cost drivers 19
Step 3 – Establish activity cost pools and determine first stage allocation Firststage 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. 20
Extendsthe use of ABC from product costing to a comprehensive management tool that focuses on reducing costs and improving processes and decision making.Decisions In ABM Product pricing and mix decisions Cost reduction and process improvement decisions Design decisions
ABC gives management insight into the coststructures for making and selling diverse products. It provides more accurate product costinformation and more detailed informationon costs of activities and the drivers of those costs.
Manufacturing and distribution personnel useABC systems to focus on cost-reduction efforts. Managers set cost-reduction targets in terms ofreducing the cost per unit of the cost-allocation base.
Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can work with their customers toevaluate the costs and prices of alternative designs.
ABM classifies all activities as value-added or non-value-added. Value-added activities increase the worth of a product or service to the customer. Example: Addition of a sun roof to an automobile. Non-value added activities don’t. Example: The cost of moving or storing the product prior to sale.
EVOLUTION OF ACTIVITY BASED COSTING IN THE CONTEXT OF A PRODUCT LIFE CYCLE Case summarizes the history of ABC according to the phases of its life cycle, highlights its expanding functionality over time, and details the lessons learned from two decades of use. It concludes with a description of the current state of ABC as a key input and value adder to performance management systems.
Increased Japanese competition experienced by western companies, particularly those in the electronics and automotive verticals. Resulted into low-wage labor & undervaluation of currencies. Some western companies retreated and complained of unfair competition, and others adopted the management practices used at leading Japanese companies such as Toyota. A few western companies developed innovative practices of their own, including innovative costing
Tektronix, for example, allocated manufacturing overhead to products based on direct labor, which encouraged engineers to design products that required less labor to manufacture. It increased the cost of purchasing, receiving, and stocking thousands of different parts, thereby reducing profitability and ultimately Tektronix’s competitiveness. Only when the cost of procurement was allocated to products based on the basis of activities, bias corrected and engineers encouraged to use common parts wherever possible.
Most of the large consulting firms built ABC practices in the late 80s and early 90s, and the first commercially available software for ABC was introduced in 1990. Underlying this enthusiasm was the recognition that ABC could yield important insights into profitability.This was because ABC: Eliminated the product cross subsidies inherent in cost accounting Revealed the sources of loss that were responsible for the decline in profitability And acted as a catalyst for decisions affecting profitability.
Systems helped management see the profitability of products and eliminate time onnon profitable products.
ABC was also the victim of shifting attention to new management methods. Some argued that ABC was inconsistent with the principles of continuous improvement and total quality management. They wrote that ABC lacked customer focus, was not process oriented, did not enhance organizational learning, and was top down in approach (i.e., did not involve employees). A common argument was that ABC could not reliably measure the short-term impact of decisions on operating cost, inventory.
For instance, in the case where ABC revealed that 80% of a company’s products were unprofitable, management denial precluded meaningful change. One company’s ABC model was so complex it was costly to maintain and difficult to understand. Interest in ABC declined after 1992 when attention turned to business process reengineering, enterprise resource planning (ERP) systems and the balanced scorecard. The good news is that ABC crossed the chasm of failure and continued its learning and development.
With continued development, however, it was clear that ABC was applicable to areas outside the scope of cost accounting. These areas included administration, sales, marketing, research and development, supply chain, and logistics. ABC implementations expanded into insurance, healthcare, packaged goods, energy, banking and other industries.
Government agencies and the military used ABC to help ameliorate budget pressures. Another development involved creating detailed models of business processes. The process models revealed opportunities for cost reduction, helped prioritize opportunities based on cost, time and quality, and allowed tracking of the impact of improvements on resource capacity.
A survey by Business Finance in 2004 indicated that 37% of companies with annual revenues in excess of $1 billion had established ABC programs. ERP systems effectively integrated transactions but were unable to guide management which products and services to sell, and which customers to serve. ABC corrected these omissions and revealed opportunities to improve financial performance.
New uses of ABC were developed such as Shared services pricing models for IT. Other corporate functions to support service level agreements (SLAs) with business units. Target costing for product design. Optimization of logistics. Supply chain and IT investments. Minimization of the total cost of ownership of equipment and other assets.
ABC evolved greatly over more than two decades. Understanding the cost-effectiveness of today’s ABC is important to assessing its value as a strategic tool in today’s hyper competitive and volatile global economy.