ACTIVITY-BASED COSTING Presented by: Komathi Palasubramaniam 811989Navaneetham Your Rajah812012Veshaleni Sritharan816491Jayamalini Subramaniam817204Gpoovaneswary Ganesan814152Presented for:Dr.Norshafizah HanafiDate:19th October 2014

OVERVIEW OF ACTIVITY BASED COSTING (ABC)To support compliance with financial reporting requirements, a companys traditional cost-accounting system is often articulated with its general ledger system.In essence, this linkage is grounded in cost allocation.Typically, costs are allocated for either valuation purposes (i.e., financial statements for external uses) or decision-making purposes (i.e., internal uses) or both.However, in certain instances costs also are allocated for cost-reimbursement purposes (e.g., hospitals and defense contractors).

The traditional approach to cost-allocation consists of three basic steps:

Cont

Costs derived from this traditional allocation approach suffer from several defects that can result in distorted costs for decision-making purposes.

For example, the traditional approach allocates the cost of idle capacity to products. Accordingly, such products are charged for resources that they did not use.

Seeking to remedy such distortions, many companies have adopted a different cost-allocation approach called activity-based costing (ABC).

What is ABC???

EXPLAINATION OF ABCABC systems first accumulate overhead costs for each organizational activity, and then assign the costs of the activities to the products, services, or customers (cost objects) causing that activity.As one might expect, the most critical aspect of ABC is activity analysis.Activity analysis is the processes of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service.An activity is any event or transaction that is a cost driver.

ContTwo common types of activity measures:-

Transaction Driver Duration Driver

Simple count of the number of times an activity occursA measure of the amount of time needed for an activity

ContExamples of activities that are cost drivers include:-Machine setupsPurchase ordersMachine timePower consumedFlight hours loggedMaintenance request

Activity analysis provides the foundation for remedying the distortions inherent in traditional cost-accounting systems.

HOW COST ARE TREATED UNDER ABC?In traditional cost accounting system, only manufacturing costs are assigned to products.

Selling, general, and administrative expenses are treated as period costs and are not assigned to products.

However, many of these non-manufacturing costs are also part of the costs of producing, selling, distributing, and servicing products.

ContFor example commissions paid to salespersons, shipping costs, and warranty repair costs can be easily traced to individual products.

The term overhead is usually used to refer non-manufacturing costs as well as indirect manufacturing costs under an ABC system.

In activity based costing, products are assigned all of the costs, manufacturing as well as non-manufacturing that they can reasonably be supposed to have caused.

The entire cost of the product is determined rather than just its manufacturing cost.

Manufacturing CostNon-manufacturing CostTraditional Product CostingABC Product CostingCont

ContTraditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products.

ABC defines five levels of activity that largely do not relate to the volume of units produced.

Manufacturing companies typically combine their activities into five classifications.

FIVE LEVEL OF ACTIVITY OF ABC

LEVEL OF ACTIVITIESTo identify resource costs for various activities, a firm classifies all activities according to the way in which the activities consume resources.

Unit Level Activity

A unit-level activity is performed on each individual unit of product or service of the firm. (Examples :- direct materials, direct labor-hours)

A unit-level activity is volume-based.

The required activity varies in proportion with the quantity of the cost object.

ContBatch-level Activity A batch-level activity is performed for each batch or group of units of products or services. (Examples setting up machines, placing purchase orders, scheduling production)

A firm incurs a batch-level activity for each batch or group of units of products or services scheduled to be processed together, rather than for each individual unit of the cost object.

ContProduct Level Activity A product-level activity supports the production of a specific product or service. (Examples of product-sustaining activities include designing products, administering parts required for products)

iv. Customer Level ActivityRelate to specific customers and include activities such as sales calls, catalog mailing, and general technical support that are not tied to any specific product.

Contv. Organization Sustaining Level Activity

A facility-level activity supports operations in general. (Examples of facility sustaining activities include providing security and safety, performing maintenance of general purpose machines)

These activities are not caused by products or customer service needs and cannot be traced to individual units, batches, or products.

Some firms refer to these activities as business or infrastructure sustaining activities.

DESIGNING ABC SYSTEMThree essential characteristics of successful ABC implementation

Top managers support

Ensure ABC data linked on people evaluation and rewards

Cross functional team formed to design and implement ABC system.

ABC Model

Cost Objects(Products & Customer)ActivitiesConsumption of ResourcesCost

Step 1: Define Activities, Activity Cost Pool, and Activity Measures

The first step in designing an ABC system is to conduct an activity analysis to identify the resource costs and activities of the firm.

Examples of these accounts include supplies, purchasing, materials handling, warehousing and etc.

Special effort will be needed to determine appropriate resource costs for activity-based costing because generally several different resource costs may be recorded in a single account or the costs for an activity may be recorded in several accounts.

ContThrough activity analyses a firm identifies the work it performs to carry out its operations.

Activity analyses include gathering data from existing documents and records, as well as collecting additional data using questionnaires, observations, or interviews of key personnel.

In this step activities should be grouped together at the appropriate level.

Example of Cost Pools and Activity Measures

Activity Based Pools at Classic Brass IncActivity Cost PoolsCustomer orders Number of customer ordersProduct Design Number of product designsOrder size Machine - Hours Customer Relations Number of active customOther Not Applicable

Cost PoolProduct DesignAll costs of resources consumed by designing the products.The activity measure for this cost pool is the number of products designed.This is product level activity.

Order SizeAssigned to all costs of resources consumed as a consequences of the number of units produces (includes cost of miscellaneous).This activity measure for this cost pool is machine hours.

ContCustomer RelationsAssigned all costs associated with maintaining relations with customers.

Including costs of sales calls and the costs of entertaining customers.

The activity measure for this cost pool is number of customers the company has on its active customer list.

ContOther Cost Pool All overhead costs that are NOT associated with customers orders, product design, the size of the orders, or customers relations.

This type of costs mainly consists of organization sustaining costs.

These costs WILL NOT to be assigned to products because they represent resources that are not consumed by products.

Step 2: Assign Overhead Costs to Activity Cost Pools

Activity-based costing uses resource consumption cost drivers to assign resource costs to activities.Because activities drive the cost of resources used in operations, a firm should choose resource consumption cost drivers based on cause and effect relationships.Resource consumption cost drivers include the number oflabor hours for labor intensive activities.Employees for payroll-related activities Setups for batch-related activitiesMoves for materials-handling activitiesMachine-hours for machine repair and maintenanceSquare feet for general maintenance and cleaning activities

ContThe cost of the resources can be assigned to activities by direct tracing or estimation.

Direct tracing requires measuring the actual usage of resources by activities.

When direct tracing is not available, department managers and supervisors need to estimate the amount or percentage of time (or effort) employees spend on each identified activity.

Example Overhead Cost

Step 3: Calculate Activity RatesThe activity rates that will be used for assigning overhead costs to products and customers.Activity Rate : Total Cost Total ActivityExample 1 : Total cost for customers orders $ 320000Total Customer orders 1000

Cont=$320,000 1000 orders= $320 per Example 2:Total cost product design $252,000400 designs

= $252,000 400= $ 630 per design

Computation of Activity Rates

Step 4: Assigning Overhead Costs to Cost ObjectsThis step of ABC called second stage allocation.In this stage activity rates are used to apply overhead costs to products and customersThis step is to assign costs of activities or activity cost pools to cost objects based on the appropriate activity consumption cost drivers.Outputs are the cost objects for which firms or organizations perform activities. Typical outputs for a cost system are products and services however, outputs also can include customers, projects, or business units.Firms use activity consumption cost drivers to assign activity costs to cost objects.

Example Overhead Cost to Cost Objects

Example of Overhead Cost to Customers

Step 5: Prepare Management ReportsThe reports prepared with ABC data are product and customer profitability reports.This report help companies channel their resources to their most profitable growth opportunities

COMPARISON OF TRADITIONAL AND ABC PRODUCT COSTIn traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels. Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

ContBasically, thetraditional costingis used commonly by manufacturing companies to assign manufacturing overheads to the units they produce. Using this, only the products are assigned an overhead cost by the accountant. The downside of this method of costing is that it neglects to consider the non-manufacturing costs like administration expenses which are associated with production. Today, such method is considered outdated because a lot of the manufacturing companies already use computers and machines for their production. Also business accounting software is already being used widely. On the brighter side, the traditional costing is easy to use especially for those companies that have one product.

ContActivity-based costing (ABC)is a more logical method of assigning manufacturing overhead costs to products. Unlike traditional costing that simply assigns costs based on the machine work hours, the ABC assigns costs first to the activities and processes that cause the overhead. Then, these costs are assigned only to the products that require the activities. Simply saying, the ABC is typically used as a supplemental costing system for businesses.

ContThe traditional costing method focuses on structure rather than on processes while the ABC is more on the activities than on structure.Traditional costing method is already obsolete especially with the changing technology trends such as the introduction of the business accounting software.The ABC provides more accurate costs of products.

TRADITIOANAL COSTING SYSTEMS

ACTIVITY-BASED COSTING SYSTEMS

EXAMPLEA simple example of these costing methods can be demonstrated with the costs of living in an apartment with roommates. Two roommates in an apartment will typically split the costs of rent, utilities and groceries, and they have a couple of options for doing so. They could simply total the cost of all of the bills and divide it exactly in two. This would be similar to traditional costing.The roommates also have the option of determining who uses specific utilities and paying only for what each one uses. They can then create an itemized bill for each roommate. For example, if one roommate doesnt use the internet and the other doesnt use cable, they wont have to pay those parts of the bill. This method is similar to activity-based costing.

Advantages of ABCABCprovides a more accurate cost per unit. As a result, pricing, sales strategy,performance management anddecision makingshould be improved.It provides much better insight into what drives overhead costs.ABC recognizes that overhead costs are not all related to production and sales volume.In many businesses, overhead costs are a significant proportion of total costs, and management needs to understand the drivers of overhead costs in order to manage the business properly. Overhead costs can be controlled by managing cost drivers.

ContIt can be applied to derive realistic costs in a complex business environment.ABC can be applied to all overhead costs, not just production overheads.ABC can be used just as easily in service costing as in product costing.

Disadvantages of ABCABC will be of limited benefit if the overhead costs are primarily volume related or if the overhead is a small proportion of the overall cost.It is impossible to allocate all overhead costs to specific activities.The choice of both activities and cost drivers might be inappropriate.ABC can be more complex to explain to the stakeholders of the costing exercise.The benefits obtained from ABC might not justify the costs.Other systems may need to be changed - for example, howvariancesare calculated.

ACTIVITY BASED MANAGEMENTIn order to manage costs, a manager should focus on the activities that give rise to such costs.

Accordingly, given the activity focus of ABC, managers should implement ABC systems in order to facilitate cost management.

Using ABC systems to improve financial management is called activity-based management (ABM).

The goal of ABM is to improve the value received by customers and, in doing so, to improve profits.

The key to ABM success is distinguishing between value-added costs and non-value-added costs.

A value-added cost is the cost of an activity that cannot be eliminated without affecting a products value to the customer.

In contrast, a non-value-added cost is the cost of an activity that can be eliminated without diminishing value.

Cont

Some value-added costs are always necessary, as long as the activity that drives such costs is performed efficiently.

However, non-value-added costs should always be minimized because they are assumed to be unnecessary.

Examples of non-valued added activities include storing and handling inventories; transporting raw materials or partly finished products, such as work-in-process inventory items, from one part of the plant to another; and redundancies in production-line configurations or other activities.

Cont

THANK YOU.END OF SLIDE

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