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Traditional & Abc


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Traditional & Abc

  1. 1. Overheads are absorbed on volume related measures like:  Number of units produced  Amount of material consumed  Amount of direct labour cost  Machine hours  Direct labour hours But there are many activities not related to physical volume.
  2. 2. Overheads have been allocated to products by using three steps: (i) From ledger accounts to production and service departments (ii)From service departments to production departments (iii)From production departments to end products
  3. 3. Overhead Cost Stage 1: Overheads assigned to production departments Production Departments Products Stage 2: Overheads allocated to products Departmental overhead allocation rates
  4. 4. 1)Blanket overhead recovery acceptable when valuing stocks for financial reporting but inappropriate when used for decision making and typical product strategy decisions. Such decisions have implications over 3-5 years and over this period many fixed costs become variable.
  5. 5. 2)Traditional fixed versus variable cost split is often unrealistic since as business grows they often become more complex. 3)Decisions based on distorted cost information because of difficulties in traditional costing system in collection, classification, allocation and recovery of overheads to individual products.
  6. 6. 4)Traditional accounting confined merely to furnishing information at product level. The new manufacturing technology demands the feedback of performance while production is still in progress rather than history. To overcome these inadequacies of overhead absorption and short term biasing of marginal costing, Activity Based Costing (ABC) has been researched
  7. 7. ABC is a technique under which the overhead costs of the organization are identified with each activity, which is acting as the cost driver. Examples of cost drivers are: Machine set-ups, purchase orders, quality inspections, power consumed, miles driven etc.
  8. 8. Activity Based Costing (ABC) is that costing in which costs are first traced to activities and then to products. The more complex an organization’s operations , the more cost driving activities it is likely to have.
  9. 9. Overhead Cost Stage 1: Overheads assigned to cost centres / cost pools Activity Cost pools Activity Cost driver rates Products Stage 2: Overheads assigned to products using cost driver rates
  10. 10. The key areas of ABC are:  Product Cost differentiation  Activities and their cost drivers  Identification of non-value added cost
  11. 11.  Identify the functional areas or major activities involved in production.  Examples: machine related activities, divert labour related activities, support activities like ordering, receiving etc.  The activities may fall into four categories  Unit level activities or Primary Activities  Batch Level Activities  Product Level Activities  Facility Level Activities
  12. 12.  Activities performed each time a unit is produced.  They are repetitive activities  Example: Direct labour hours, Machine hours, Power are used each time a unit is produced  Costs of unit level activities vary with the number of units produced
  13. 13.  Activities performed each time a batch of goods or products is produced  Costs of batch level activities vary with the number of batches but are fixed with respect to the number of units in each batch  Example: Machine setups, inspections, production scheduling, materials handling
  14. 14.  Activities performed to support the production of each different type of product  Example: Maintenance of equipment, engineering charges, testing routines, maintaining bills of materials
  15. 15.  Activities needed to sustain a factory’s general manufacturing process  These are common to a variety of products  Most difficult to link to product specific activities  Examples: Factory management, maintenance, security, plant depreciation
  16. 16.  A cost centre also called a cost pool be created for each activity.  Cost of resources consumed over a specified period must be assigned to each activity  These costs will have to be apportioned on some suitable basis.  Example: Total costs of all set ups might constitute one cost centre for all setup related costs.
  17. 17.  Cost Driver is a factor that influences cost  Most suitable cost driver in each activity under functional areas should be identified  Example: In production scheduling, driver will probably be the number of batches ordered.
  18. 18. FUNCTIONAL AREAS ACTIVITIES SUITABLE COST DRIVERS Materials Management • Issue of purchase orders • Number of purchase orders • Inspection of materials • Number of purchase orders Stores Management • Storing of materials • Value of materials stored • Servicing of requisitions • Number of requisitions • Inspection & Verification • Number of times inspected • Stock Taking • Value of stock Quality Control • Testing of Samples • Number of batches produced
  19. 19. FUNCTIONAL AREAS ACTIVITIES SUITABLE COST DRIVERS Marketing • Demand Creation • Increase in sales • Advertising • Increase in sales • Despatches •Number of orders Personnel Management • Recruitment of employees • Number of employees recruited • Maintenance of leave records & attendance • Number of employees Research & Development • Research • Number of research Projects Machining • Setup Cost • Number of production runs • Power cost •Machine hours
  20. 20.  Cost of the activities is traced to products on the basis of their usage of the activity, expressed in terms of the chosen cost driver(s).  Example: Thus a batch generating 3 purchase orders would be charged 3 x Rs. 200 = Rs. 600 for purchasing overheads. Total Costs of purchasing Rs. 2,00,000 Number of Purchase Orders 1,000 Cost Driver rate Rs. 200
  21. 21. ABC is needed in organizations for product costing where:  Production overheads are high in relation to direct costs  There is a great diversity in product range  Products use different amounts of overhead resources  Consumption of overhead resources is not primarily driven by volume
  22. 22. TRADITIONAL ABC 1. Cost Pools One or a limited number Many, to reflect different activities 2. Applied Rate Volume based, financial Activity based, non – financial 3. Suited for Labour intensive, Low overhead companies Capital intensive, product diverse, high overhead companies 4. Benefits Simple, inexpensive Accurate product costing, possible elimination of non- value –added activities
  23. 23. The following are the advantages of ABC:  Helps in reducing costs by providing meaningful information for cost management which helps in making the right decision  Provides due importance to non- manufacturing cost which constitute a substantial portion of total cost  Provides reliable and accurate cost information
  24. 24.  Enables management in formulating an effective pricing policy while fixing prices  Accuracy in indirect cost allocation to products, helpful in make or buy decisions and transfer pricing  Uses multiple cost drivers since concerned with all activities within & beyond the factory
  25. 25.  Can be more complex than traditional since uses numerous cost pools & multiple cost drivers  Difficulties in the implementation of ABC system such as selection of cost drivers, assignment of common costs, varying cost driver rates etc.
  26. 26.  Different levels of utility for different organizations such as beneficial for large manufacturing firms as compared to smaller firms, advantageous for firms following cost plus pricing as it gives accurate product cost.  Can prove costly to manage ABC System
  27. 27. Most common motives for establishing ABC System are:  To improve product costing where a belief exists that existing methods undercost some products and overcost others, or  To identify non value adding activities in the production process which might be a suitable focus for attention or elimination
  28. 28. Number of distinct practical stages in ABC implementation are:  Staff Training: Co-operation of work force is critical to successful implementation of ABC as they are closest to the process and most aware of the problems
  29. 29.  Process Specification: Informal but structured interviews with key personnel will identify different stages of production process, commitment of resources to each, processing times and bottlenecks.  Activity definition: listed transactions must be rationalized in order to aggregate those in similar categories and eliminate those deemed immaterial.
  30. 30.  Activity Driver Selection: Single driver covering all transactions grouped together in an ‘activity’ probably does not exist and multiple driver models are not desirable as seen from the cost benefit analysis  Costing: Single representative activity driver can be used to assign costs from activity pools to the cost objects.
  31. 31.  ‘Service organizations ideal candidates for ABC’ Kaplan & Cooper  Due to privatization, deregulation & increasing competition, service organizations need to accurately measure cost and resulting profitability for their services, customers and markets.  ABC can understand their cost base and make decisions on value added/ non value added activities
  32. 32. ABC supports Corporate Strategy in many ways:  Accurate product costing helps management compare profits from various customers, product lines, brands or regions. Takes decisions on pricing strategy, dropping unprofitable products, lines etc.  Helps in redesigning products  Evaluate new process technologies
  33. 33.  Reduce setup times  Rationalization of plant lay out to reduce material handling cost  Reduction in demand for organizational resources by comparing resource spending and resource consumption  Helps managers to focus their attention & energy on improving activities  Activity performance and efficiency can be measured – helps in budgeting
  34. 34. XYZ Co. has 3 clerks responsible for processing purchase invoices. Salary paid to them is Rs. 3,00,000 p.a. and invoices processed by them are 5000 per year. In addition to salary, company spends Rs. 90,000 per year for forms, postage etc. During the year 12,500 invoices were processed. Required (i) activity rate for purchase order activity and break it into fixed & variable components (ii) total activity availability and break it into activity usage & unused activity (iii) total cost of resources supplied broken into activity usage & unused activity.
  35. 35. (i) Activity Rate = = Rs. 66 per invoice Fixed Activity Rate = = Rs. 60 per invoice Variable activity rate = = Rs. 6 per invoice (ii) Activity availability = Activity usage + unused activity = 12,500 invoices + 2500 invoices = 15,000 invoives
  36. 36. 3. Costs of resources supplied = Cost of activity used + cost of unused activity Rs. 9,00,000 + (Rs. 6 x 12,500)= (Rs. 66 x12,500) + (Rs. 60 x 2500) Rs. 9,75,000 = Rs. 8,25,000 + 1,50,000
  37. 37. A company manufacturing two products furnishes the following data for a year: Product Annual Output (units) Total Machine hours Total number of purchase orders Total number of set-ups A 5,000 20,000 160 20 B 60,000 1,20,000 384 44 The annual overheads are as under: Volume related activity costs Rs. 5,50,000 Set up related costs Rs. 8,20,000 Purchase related costs Rs. 6,18,000 Calculate cost per unit of each Product A&B based on (a) Traditional Method of charging overheads (b) Activity based costing method
  38. 38. (a) Traditional method of charging overheads: Rs. Volume related activity costs 5,50,000 Set-up related costs 8,20,000 Purchase related costs 6,18,000 Total Costs 19,88,000 Total Machine Hours (20,000 +1,20,000) = 1,40,000 Total cost per hour (Rs. 19,88,ooo/ 1,40,000) = Rs. 14.20 Cost per unit of A = (20,000 x Rs. 14.20)/5000 = Rs. 56.80 Cost per unit of B = (1,20,000 x Rs. 14.20)/ 60,000 = Rs. 28.40
  39. 39. (b) Activity based costing method of charging overheads: Volume related activity cost per machine hour: Rs. 5,50,000/ 1,40,000 = Rs. 3.9286 Set-up costs per set up: Rs. 8,20,000/ 64 = Rs. 12,812.50 Purchase related costs per purchase order: Rs. 6,18,000/ 544 = Rs. 1136.029 Cost per unit of product Particulars Cost Driver A B Volume related costs Machine hours Rs. 78, 572 Rs. 4,71,432 Set-up Costs Number of set ups 2,56,250 5,63,750 Purchase related Costs Number of Purchase Orders 1,81,765 4,36,235 Total Costs Rs. 5,16,587 14,71,417 Cost per unit Rs. 103.32 Rs. 24.52