Ch 12 ABC Costing Example

5/26/2018 Ch 12 ABC Costing Example

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ctivity Based Costing


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Traditional Costing Systems

Product Costs

Direct labor

Direct materials

Factory Overhead

Period Costs

Administrative expense

Sales expense

Appear on the income

statement when

goods are sold, prior

to that time they are

stored on the balance

sheet as inventory.

Appear on the income

statement in the

period incurred.


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Product Costs

Direct labor

Direct materials

Factory Overhead

Period Costs

Administrative expense

Sales expense

Direct labor and direct

materials are easy to

trace to products.

The problem comes

with factoryoverhead.


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Typically used one rate to allocate overhead to

products.

This rate was often based on direct labor

dollars or direct labor hours.

This made sense, as direct labor was a major

cost driver in early manufacturing plants.


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Problems with Traditional Costing

Systems

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.


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Todays Manufacturing Plants

Are more complex

Are often automated

Often make more than one product Use proportionately smaller amount of direct

labor

making direct labor a poor allocation base forfactory overhead.


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When the manufacturing process is

more complex:

Then multiple allocation bases should be

used to allocate overhead expense.

In such situations, managers need toconsider using activity based costing

(ABC).


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ACTIVITY BASED COSTING


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Activity Based costing is recent development in Cost

Accounting which attempts to absorb overheads into

product cost on more realistic basis.

ABC focusses on activities as fundamental cost

objects.ACTIVITIES

COST

DRIVERS

COST OF ACTIVITIES

___________________

COST POOLS

COST

ALLOCATED TO

COST OBJECTS

An activity is a process or procedure that causeswork. In relation to ABC, we only mean activities of

support or service departments, such as material

handling, quality testing, inspection etc. Activitiesconsume resources.

ABC differ from traditional system only in respect of

allocation of overheads or indirect cost.


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DIRECT COST

INDIRECT COST

COST

ASCERTAINMENT

COST OF PRODUCT

OR SERVICE

COST TRACING

COST ALLOCATION

TRADITIONAL COSTING ACTIVITY BASED COSTIN

Volume based allocation bases e.gLabour-hours, machine hours

Cost Divers are used as

allocation bases e.g, Set-up

hours for set-up cost;

inspection hours for

allocating inspection cost;

testing hours for allocating

quality cost and so on..


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Cost is allocated based on drivers .Cost driversare factors

or transaction that are significant determinants of costs.

For e.g, purchasing departments cost depends on number ofpurchase order placed, costs of warehousing depends upon

number of items in stock, machine set-up cost depends on

number of set-up per periods etc.

ACTIVITY COST DRIVERS

Machine set-up Number of production runs

Purchasing material Number of orders placed

Warehousing Items in stock

Material handling Number of parts

Inspection Inspection per item

packing Number of packing order


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In ABC, a cause and effect relationship is established.

Cost are allocated based on demands on resources.

RESOURCES

COST/EXPENSES

ACTIVITIES

Create

Drive

Measurement of

Consumption of resources

ABC focusses on activities for cost management.

Traditional system focusses on cost the effect rather

than on the cause

the activity


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ABC Steps

Overhead cost drivers are determined.

Activity cost pools are created.

A activity cost pool is a pool of individual costs

that all have the same cost driver.

All overhead costs are then allocated to one of

the activity cost pools.


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ABC Steps:

An overhead rate is then calculated for each

cost pool using the following formula:

Costs in activity cost pool/base

The base is, of course, the cost driver

Overhead costs are then allocated to each

product according to how much of each base

the product uses.


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Example

Lets illustrate the concept of activity based

costing by looking at two common

manufacturing activities: (1) the setting up of

a production machine for running batches ofproducts, and (2) the actual production of the

units of product.


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We will assume that a company has annual

manufacturing overhead costs of

$2,000,000of which $200,000 is directly

involved in setting up the productionmachines. During the year the company

expects to perform 400 machine setups. Lets

also assume that the batch sizesvaryconsiderably, but the setup efforts for each

machine are similar.
http://www.accountingcoach.com/terms/B/batch-size.htmlhttp://www.accountingcoach.com/terms/B/batch-size.html


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The cost per setup is calculated to be $500

($200,000 of cost per year divided by 400

setups per year). Under activity based costing,

$200,000 of the overhead will be viewed asa batch-level cost. This means that $200,000

will first be allocated to batches of products to

be manufactured (referred to as a Stage 1allocation), and then be assigned to the units

of product in each batch (referred to as Stage

2 allocation).
http://www.accountingcoach.com/terms/B/batch-level-cost.htmlhttp://www.accountingcoach.com/terms/S/stage-one-allocation.htmlhttp://www.accountingcoach.com/terms/S/stage-one-allocation.htmlhttp://www.accountingcoach.com/terms/S/stage-two-allocation.htmlhttp://www.accountingcoach.com/terms/S/stage-two-allocation.htmlhttp://www.accountingcoach.com/terms/S/stage-two-allocation.htmlhttp://www.accountingcoach.com/terms/S/stage-two-allocation.htmlhttp://www.accountingcoach.com/terms/S/stage-one-allocation.htmlhttp://www.accountingcoach.com/terms/S/stage-one-allocation.htmlhttp://www.accountingcoach.com/terms/B/batch-level-cost.htmlhttp://www.accountingcoach.com/terms/B/batch-level-cost.htmlhttp://www.accountingcoach.com/terms/B/batch-level-cost.html


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For example, if Batch X consists of 5,000 units

of product, the setup cost per unit is $0.10

($500 divided by 5,000 units). If Batch Y is

50,000 units, the cost per unit for setup willbe $0.01 ($500 divided by 50,000 units). For

simplicity, lets assume that the remaining

$1,800,000 of manufacturing overhead iscaused by the production activities that

correlate with the companys 100,000

machine hours.


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For our simple two-activity example, let's see how the rates for allocating the

manufacturing overhead would look withactivity based costing and withoutactivity

based costing:


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Next, let's see what impact these different allocation techniques and

overhead rates would have on the per unit cost of a specific unit of output.

Assume that a company manufactures a batch of 5,000units and it produces

50 units per machine hour, here is how the cost assigned to the units with

activity based costing and without activity based costing compares

If f t b t h f 50 000 it d


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If a company manufactures a batch of 50,000units and

produces 50 units per machine hour, here is how the

cost assigned to the units with ABC and without ABC

compares:


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As the tables above illustrate, with activity based

costing the cost per unit decreases from $0.46 to

$0.37 because the cost of the setup activity is spread

over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of

the number of units in each batch.

If companies base their selling prices on costs, a

company notusing an ABC approach might lose the

large batch work to a competitor who bids a lower

price based on the lower, more accurateoverhead

cost of $0.37.


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Its also possible that a company not using

ABC may find itself being the low bidder for

manufacturing small batches of product, since

its $0.40 is lower than the ABC model of $0.46for a batch size of 5,000 units.

With its bid price based on manufacturing

overhead of $0.40but a true cost of $0.46the company may end up doing lots of

production for little or no profit.


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Our example with just two activities

(production and setup) illustrates how the

cost per unit using the activity based costing

method is more accurate in reflecting theactual efforts associated with production.


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As companies began measuring the costs of activities (instead

of focusing on the accountants departmental classifications),

they began using ABC cost information to practice activity

based management. For example, with the cost of setting up

a machine now being measured and discussed, managersbegan to ask questions such as:

Why is the cost of setting up a production machine so expensive?

What can be done to reduce the setup cost?

If the setup costs cannot be reduced, are the selling prices

adequate to cover all of the companys costsincluding the

setup cost that was previously buried in the overall machine-

hour overhead rate?


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When do we use ABC costing?

When one or more of the following conditions are

present:

Product lines differ in volume and manufacturingcomplexity.

Product lines are numerous and diverse, and theyrequire different degrees of support services.

Overhead costs constitute a significant portion of totalcosts.

The manufacturing process or number of products haschanged significantlyfor example, from laborintensive to capital intensive automation.


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ADVANTAGES OF ABC

ABC system focus attention on activities rather thanproducts. Because activities of various department may be

combined and cost of similar activities ascertained, e.g

quality control, inspection, handling of material. If detailed

cost are kept by activities, the total company cost of each

activity can be obtained, analyzed, planned and controlled.

Because cost are identified with activities and thenallocated to product or services, based on appropriate cost

drivers, more accurate product/service cost results.


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Managers manage activities and not products. Changes

in activities leads to changes in cost. Therefore, if activities

are managed well, costs will fall and resulting products

will be more competitive Allocating overheads cost to production based on single

cost drivers can result in an unrealistic product cost( as in

traditional costing). To manage activities better and to

make wiser economic decision, managers need to identify

the relationship of cause( activities) and effect( cost) . ABC

focusses on this aspect.

ABC highlight problem area that deserve managementsattention and more detailed analysis.


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DISADVANTAGES OF ABC COSTING:

ABC fails to encourage manager think about changing

work processes to make business more Competitive.

ABC does not confirm to GAAP in some areas. For,

example ABC encourages allocation of non-product cost

as research and development to product cost . Whilecommitted cost such as factory depreciation are not

allocated to product.

Using ABC, for short-run decisions may sometimes

prove costly in long run.For ex, decision of lowering salesorder handling cost by reducing small order that generate

lower margin.

ABC does not encourage the identification and removal

of constraints creating delay and excesses.


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Additional Uses of ABC

Activity Based Management (ABM)

Extends the use of ABC from product costing to a

comprehensive management tool that focuses on

reducing costs and improving processes anddecision making.


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ABM

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 dont.

Example: The cost of moving or storing the productprior to sale.


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The Objective of ABM . . .

To reduce or eliminate non-value related

activities (and therefore costs).

Attention to ABM is a part of continuous

improvement of operations and activities.


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The End!

Ch 12 ABC Costing Example

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