DEFINITION: Activity Based Costing (ABC) is a managerial accounting system which determines the cost of activities without distortion

and provides management with relevant and timely information. It does not represent just a new set of overhead allocation rules or techniques to value inventory. ABC represents a way to look at operating costs and provides methods to dissect the underlying activities, which cause costs to exist. Basics of ABC: Cost of a product is the sum of the costs of all activities required to manufacture and deliver the product. Products do not consume costs directly Money is spent on activities Activities are consumed by product/services. ABC assigns Costs to Products by tracing expenses to activities. Each Product is charged based on the extent to which it used an activity. Provides ways of assigning the costs of indirect support resources to activities, business processes, customers, products.

ACTIVITY BASED COSTING

Building an ABC Model

Identify Cost Objects

Identify Resources

Identify Activities

Define Activity Drivers

Define Resource Drivers

Enter Resource Costs

Enter Resource Driver Qty.

Enter Activity Driver Qty.

Calculate Costs

THROUGHPUT COSTING
DEFINITION: Method of costing a product where only the unit-level direct costs are assigned to the product. It is a management accounting technique used as the performance measures in the Theory of Constraints (TOC). It is a relatively new management accounting approach based largely on the identification of factors that limit an organization from reaching its goal. It is neither cost accounting nor costing because it is cash focused and does not allocate all costs (variable and fixed expenses, including overheads) to products and services sold or provided by an enterprise.

Differentiate between ABC and Throughput Costing

Account based Costing 1.Refinement and improvement of classical cost accounting (absorbing accounting) Throughput Costing Updated version of contribution accounting.

2. Does not take into account impact Increase in throughput is the main on throughput focus. 3. Any increase in efficiency is acceptable. Only increases in efficiencies that increase throughput or that reduces overall costs are acceptable. It considers operating expenses be a lesser concern and makes no attempt to allocate operating expenses to any type of cost object.

4.It targets operating expenses reduction .

Account based Costing

Throughput Costing

5.It works well in labor intensive It tends to yield better results in production environment where labor machine intensive production areas resources are more flexible. where machine usage is prevalent. 6.It is a complicated system to create It is much easier than ABC to calculate and maintain as it allocate costs as it completely avoids any attempt to based on cost drivers and tends to create cost pools, identify cost drivers focus management attention on or allocate costs based on those operating expenses reduction. drivers.

Illustration of ABC with 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 of products, and (2) the actual production of the units of product. It is assumed that a company has annual manufacturing overhead costs of $2,000,000of which $200,000 is directly involved in setting up the production machines. During the year the company expects to perform 400 machine setups. Lets also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar. 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 as a batch-level cost. This means that $200,000 will first be allocated to batches of products to be manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation).

For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 / 5,000 units). If Batch Y is 50,000 units, the setup cost per unit is $0.01 ($500 / 50,000 units). For simplicity, lets assume that the remaining $1,800,000 of manufacturing Overhead is caused by the production activities that correlate with the companys 100,000 machine hours. For our simple two-activity example , let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing: With ABC Without ABC Mfg overhead costs assigned to setups Number of setups Mfg overhead cost per setup Total manufacturing overhead costs $200,000 400 $500 $2,000,000 $0 N.A $0 $2,000,000

With ABC Less: Cost traced to machine setups Mfg O/H costs allocated on machine hours Machine hours (MH) Mfg overhead costs per MH Mfg Overhead Cost Allocations 200,000 $1,800,000 100,000 $18

Without ABC 0 $2,000,000 100,000 $20

$500 setup $20 per MH cost per batch + $18 per MH

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 5,000 units 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:

For Batch X Mfg. overhead for setting up machine No. of units in batch Mfg O/H caused by set up per unit Mfg O/H costs per machine hr No. of units produced per hr Mfg O/H caused by production per unit hr Total Mfg O/H Allocated per hr

With ABC $ 500 500 $0.10 $18 50 $0.36 $0.46

Without ABC 0 N.A. N.A. $20 50 $0.40 $0.40

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost assigned to the units with ABC and without ABC compares: For Batch Y Mfg overhead for setting up machine No. of units in batch Mfg O/H caused by Setup Per Unit Mfg overhead costs per machine hour No. of units produced per machine hour Mfg O/H caused by Production Per Unit Total Mfg O/H Allocated Per Unit With ABC $50 050,000 $0.01 $18 50 $0.36 $0.37 Without ABC $0 N.A. N.A $20 50 $0.40 $0.40

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 not using an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more accurate overhead cost of $0.37. 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 $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40but a true cost of $0.46 the company may end up doing lots of production for little or no profit. 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 the actual efforts associated with production. 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.