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Activity based costing


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Activity Based Costing used for Costing the different products based on the activities involved

Published in: Economy & Finance

Activity based costing

  1. 1. Activity Based Costing<br />
  2. 2. What is ABC?<br />Activity Based Costing is a management accounting approach which allocate all direct and indirect (overhead) costs to cost objects (products and services) in order to help management understand critical business information.<br />It allocates direct and indirect costs to products and services based on the level of activities used to create and deliver those products and services.<br />
  3. 3. Direct & Indirect Costs?<br />Direct costs A cost that can be directly traced to producing specific goods or services., e.g., salaries for project staff and materials required for a particular project.<br />Indirect costs are costs that are not directly accountable to a cost object (such as a particular function or product). Indirect costs may be either fixed or variable. Indirect costs include taxes, administration, personnel and security costs, and are also known as overhead.<br />
  4. 4. Activities such as purchasing, design, production, sales, marketing and customer service are utilized by different products and services (cost objects) based on their complexity and business requirements.<br />Compared to traditional accounting, activity based costing is a decision making tool which provides more accurate cost and profit information and allows management to understand the cost and profit drivers and improve their business.<br />
  5. 5. ABC Vs. Traditional Methods<br />Resources<br />Resources<br />Everything in the organization<br />Consume<br />Traced by Resource Drivers<br />Activities<br />What is actually being done<br />Allocation Basis<br />Allocate<br />Consume<br />Traced by Activity Drivers<br />Objects<br />Objects<br />-Products<br />-Services<br />
  6. 6. Difference between Traditional & ABC Method<br />In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.<br />Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.<br />Traditional cost accounting is structure-oriented whereas ABC is process-oriented.<br />
  7. 7. Steps necessary to develop ABC System:<br />Identifying available resources & resource-consuming activities<br />Assigning costs of available resources to activities<br />Assigning costs of activities to cost objects(i.e. products, batches of products)<br />How ABC Works<br />
  8. 8. 1. Identifying available resources & resource-consuming activities<br />Identify resources<br />Resource Consumption Cost Drivers<br />Transaction Drivers<br />Duration Drivers<br />Activity Levels: There are different activity levels such as:<br />unit level activities (activities performed on each unit such as packaging), <br />batch level activities (activities performed on batch level such as scheduling and set up), <br />product level activities (activities performed on each product such as design, engineering and marketing) and <br />facility level activities (activities performed at each facility such as safety and maintenance).<br />
  9. 9. 2. Assigning costs of available resources to activities<br />Assign the cost of resources to the activities that consume those resources, for this company will choose resource consumption cost drivers. E.g. if a machine(m/c) set-ups activity requires 0.5m/c hrs, and each m/c hr costs $20 then m/c set-ups activity costs $10($20x0.5).<br />Assigning cost of resources to the activities consuming those resources, a company can determine the cost of each activity and ultimately cost of factory’s output.<br />3. Assigning costs of activities to cost objects(i.e. products, batches of products)<br /><ul><li>Company will assign cost of activities to cost objects based on activity consumption cost drivers. Cost Objects e.g. if a cost object requires 3m/c set-ups & the m/c set-ups activity costs $10 then the cost object will be assigned $30.
  10. 10. Activity consumption drivers measure amount of activity consumed by a cost object.</li></li></ul><li>How ABC Works(Contd.)<br />
  11. 11. Example of ABC<br />Friends company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves(GSV) and MSC Valves(MSC). Friends company has following data for two products:<br />In addition, Friends company has identified the following activities, costs, and activity consumption cost drivers:<br />
  12. 12. Friends company also collected the activity data for each product:<br />Using the total cost for each activity & the total amount of activity cost driver we can determine the activity cost rate:<br />
  13. 13. Calculating per-unit cost of each product manufactured by Friends Company.<br />
  14. 14. Using the obtained data we can perform the product profitability analysis; that is, we will determine the unit margin profit of each product<br />Comparing the product profitability analysis under traditional and activity-based costing.<br />