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  2. 2. TRADITIONAL COSTING SYSTEM •It focused on product costing by tracing direct costs to the product and indirect costs are allocated through cost centres . •Traditionally , indirect costs have been allocated to the end products in three steps: 1. From ledger accounts to production and service departments. 2. From service departments to production departments following reapportionment methods of allocation. 3. Finally allocating indirect costs of production departments to the products.
  3. 3. Patio gill company used a job order product costing system to find the cost of its three products of grill the standard STD, deluxe DEL and ultimate ULT. STANDARD DELUXE ULTIMATE PLANNED ANNUAL PRODUCTION VOLUME IN UNITS PRODUCTION RUN DIRECT MATERIAL DIRECT LABOR MACHINE HOURS PER PRODUCT TOTAL MACHINE HOUR 10000 8000 2000 80 runs of 125 80 runs of 100 40 runs of 50 units units units $100 $120 $180 $180(9hours $220(11hours $260(13hour @20) @20) s@20) 10 12 17 100000 960000 340000
  4. 4. DIRECT MATERIAL DIRECT LABOR MANUFACTURING OVERHEAD TOTAL STANDARD DELUXE ULTIMATE $100 $120 $180 $180 $220 $260 $216 $264 $312 $496 $604 $752 PREDETERMINED OVERHEAD RATE BUDGETED MATERIAL OVERHEAD DIRECT LABOUR BUDGETED HOURS STD: 10000 Units*9hours DEL: 8000 Units*11hours ULT: 2000 Units*13hours TOTAL DIRECT LABOUR HOURS PREDETERMINED OVERHEAD RATE: $4,896,000/204,000= $24Per hour 90000 88000 26000 204000 Product costs from traditional, volume based product costing system: Patio Grill company
  5. 5. Trouble in patio company • Less profitability by the prodcts • Unable to achieve target price( 120% of full product cost) standard Deluxe Ultimate Production cost under traditional volume based system $496.00 $604.00 $752.00 Target selling price $595.00 $724.80 $902.40 Actual selling price $585.00 $705.00 $940.00
  6. 6. The Need for a New Approach •Tremendous change in manufacturing and service industries. •Decrease in amount of direct labour and direct material usage. •Significant increase in total overhead costs. •Intense global competition. •Costs of non – volume related activities can not be apportioned on volume basis as in traditional method. •There was an urgent need to integrate activity measurement and financial measurement.
  7. 7. Defintion as per CIMA: Cost attribution to cost units on the basis of benefit received from indirect activities such as ordering,setting up,assuring,quality.
  8. 8. Meaning: Activity based costing is an accounting methodology that assigns costs to activities rather than products or services . •Focuses on activities as the fundamental cost objects. •Costs are grouped according to what causes them to be incurred.
  9. 9. Characteristics : 1)It lays emphasis on different costs for different purposes and only those costs are identified which are relevant to a particular decision. 2)The more important distinction between cost behaviour patterns are volume related , time related and events related. 3)Cost drivers(activities those generate costs) need to be identified. 4)The reporting of costs incurred on significant activities provides basis for understanding what causes overhead costs. 4)Effective method of excercising cost control. 5)It aims at rectifying inaccurate cost information.
  10. 10. Traditional v/s ABC Approach: Traditional approach ABC approach 1)Lack of cause and effect relationship between cost allocation basis and indirect cost pools. 1)Presence of cause and effect relationship between cost allocation basis and indirect cost pools. 2)Uses a few pools of indirect costs resulting in overcosting or undercosting of products. 2)Rational basis of assigning indirect costs to various activities. 3)Wrong pricing decisions resuting in loss of market share . 3)Improved decision making such as fixing selling price and pinpointing the area where cost reduction is possible.
  11. 11. Cost driver It is a characteristic of an activity of an event or activity that results in the incurrence of costs.
  12. 12. Factors affecting selection of cost drivers • Degree of correlation • Cost of measurement • Behavioral effects
  13. 13. Activity Cost Pool: The overhead cost attributed to a distinct type of activity. For example: ordering materials or setting up machines
  14. 14. Allocation of overheads under ABC: Service departments & Factory overheads Assigning costs of Individual activities Activity cost pools Product lines Application of cost driver rates
  15. 15. Overhead costs Total budgeted cost = $4,896,000 Activity cost pools Machine related cost pool $ 1,242,000 Set up cost tool $ 210,000 purchasing cost pool $ 300,000 Quality assurance cost pool $110,000 Engineering design cost pool $ 130,000 Faci;ity cost pool $ 2,300,000 Packing cost pool $264,000 Compute product cost of patio grill under various activity pools
  16. 16. Steps involved in Activity-based costing •Identify and classify the major activities and allocate overheads to the appropriate cost pools. •Identify the cost driver that has a strong correlation to the costs in the cost pool. •Compute the overhead rate for each pool.
  17. 17. •Establish demands made by a particular product on activities using cost drivers. •Assign overhead costs to products using the overhead rates : In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product.
  18. 18. ABC Data and Calculation for the machine Related cost Pool: Patio Grill company
  19. 19. Total Product Cost as per ABC STD DEL ULT DIRECT MATERIAL $100.00 $120.00 $180.00 DIRECT LABOR $180.00 @220.00 @260.00 TOTAL DIRECT COST $280.00 $340.00 $440.00 MACHINE RELATED $54.00 $64.80 $440.00 SET UP 8.40 10.50 21.00 PURCHASING 10.00 12.00 52.00 MATERIAL HANDELING 13.60 17.00 34.00 QUALITY ASSURANCE 4.00 5.00 15.00 PACKING 12.00 12.00 24.00 ENGINEERING DESIGN 5.00 5.00 20.00 FACILITY 100.00 120.00 170.00 TOTAL INDIRECT COST $207.00 $246.30 $427.80 TOTAL PRODUCT COST $487.00 $586.30 $867.80 INDIRECT COST
  20. 20. Rules developed by Kaplan and Cooper for ABC: •Focus on expensive resources. •Emphasis on resources whose consumption varies significantly. •Focus on resources whose demand patterns are uncorrelated.
  21. 21. Stages of ABC • ABC stage one -- Overhead costs are allocated to activity cost pools. • Unit level: Performed each time a unit is produced • Batch level: Performed each time a batch is produced rather than a unit.
  22. 22. •Product-sustaining level: It includes activities that are needed to support entire product line . • Facility level [general operations level]: These activities are required in order for the entire production process to occur
  23. 23. ABC Stage two – •Cost drivers are identified for each activity cost pool. •Unit activity costs for product lines and activity cost pools are computed. •The overhead costs allocated to the cost pools is assigned to products using cost
  24. 24. Main activities and its cost drivers Main activities Cost drivers 1) Material planning • No. of material transactions •Volume of material receipts •Volume of material orders 2)Maintenance • No. of machine breakdowns •Maintenance schedule •Capital expenditure •Activity levels 3) Customer order processing •Order value •Order source •Customer location 4)Inspection •Inspection plans •Number of problem suppliers •Lack of good quality
  25. 25. Comparison of ABC v/s Traditional costing system STD Reported unit overhead cost: traditional costing system activity based costing system Reported unit product cost (direct material, direct labour and overhead): traditional costing system activity based costing system DEL ULT $216.00 207.00 $264.00 246.30 $312.00 427.80 496.00 487.00 604.00 586.30 752.00 867.80 595.20 724.80 902.40 584.40 703.56 1041.36 Sales price data: Original targey price(120% of product cost based on traditional costing system New target price(120% of product cost based on activity based costing system Actual current selling price 585.00 705.00 940.00
  26. 26. What prices should we set? Which product should we promote? Which customers are profitable? Gaining competitive advantage How should we measure performance? Which distribution channels should we follow?
  27. 27. How to implement ABC? 1)Identify functional areas. 2) Identify key activities in each functional area. 3)Allocate common indirect costs to various activities. 4)Identify most suitable cost driver in each activity under functional areas. 5)Prepare statement of expenditure activity-wise. 6)Compare it with value addition activity wise to know which activities need to be eliminated or need improvement.
  28. 28. Advantages of ABC • More accurate • Understand how costs are actually consumed • Use of more cost pools to assign overhead costs • Enhanced control over overhead costs • Better management decisions • Improvement in performance • Product/service pricing • Make or buy decision • Transfer pricing • Determination of products service costs
  29. 29. Limitations of ABC •Can be expensive to use •Does not measure incremental costs
  30. 30. Ways of achieving cost reduction under ABC Ways of achieving cost reduction ABC system 1. Reducing set up time To achieve low cost 2.Eliminating material handling activities. To reduce cost of handling 3.Using common components Wherever possible in order to save cost and time.
  31. 31. Conclusion: •In order to reduce the direct cost of the product , we can control the overheads when one has the information of cost centres. •It becomes necessary to have a costing system based on activity done. •Can not be applied if there is no clear distinction for the costs attached to various activities. •Implemented in different segments of an organisation . •Equally applied in service sectors.
  32. 32. Thank You!!