Activity based costing

Introduction and implementation

which mainly includes material and labour.Background ‡ The direct costs. creates problem for the cost accountant in determining the accurate product costs. In modern era. importance of indirect costs in the manufacturing operations is increasing and direct costs are being relegated to the background. also known as overheads. are chargeable to the end products without difficulty and are thus convenient to handle. . ‡ Indirect costs.

Cost collection and estimation Allocation Apportionment or primary distribution Re-apportionment or secondary distribution 5. 4.Traditional approach 1. Over absorption or under absorption . 3. Absorption 6. 2.

other products are undercosted. The overcosted products are subsidizing the undercosted products (Product cost cross.subsidisation) ‡ .Problems of Over absorption and under absorption ‡ Uses broad averages for charging overheads uniformly to products or services (cost smoothing or peanut butter costing) If some products are overcosted.

Activity based costing ‡ Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each. an organization can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced. . ‡ In this way.

proponents of the Balanced Scorecard. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. Kaplan. . brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988.Historical development ‡ The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s ‡ Robin Cooper and Robert S.

increased automation has reduced labor. but have increased relative proportion of indirect costs. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. ‡ For example.Historical development ‡ Activity-based costing was first clearly defined in 1987 by Robert S. but has increased depreciation. which is a direct cost. which is an indirect cost. Kaplan and W. .

. to cut a screw thread. for example. Drucker in the book Management Challenges of the 21st Century.Historical development ‡ Activity-based costing was later explained in 1999 by Peter F. activity-based costing also records the cost of not doing. such as the cost of waiting for a needed part. He states that traditional cost accounting focuses on what it costs to do something. Activity-based costing records the costs that traditional cost accounting does not do.

E.-Setting up of a machine..g. e. a job or a service. ‡ Cost driver: A factor that causes a change in the cost of an activity .Basic terminology ‡ Activity: A particular task or unit of work with a specific purpose.g. placing a purchase order ‡ Cost object: An item for which cost measurement is required.a product.

of machine hours for depreciation of machine Number of employees for labour welfare expenses .Examples of activity cost drivers ‡ ‡ ‡ ‡ ‡ No. of receiving orders for the receiving department costs No. of inspections for inspection charges No. of setups for setup costs No.

Calculation of activity cost driver rate Activity cost driver rate= total cost of activity Cost drivers 5. Charging the cost of activities to products . Identification of the main activities 2.Steps in ABC 1. Creation of cost pool 3. Determination of the activity cost drivers 4.

Products make diverse demands on resources 4. Significant amounts of costs are allocated using one or two cost pools 2.´Tell-Taleµ Signs of Need to Consider ABC 1. All or most of the costs are identified as output unit-level costs 3. Complex products appear to be profitable while simple products appear to be losing money 6. Main products show little profit while secondary products show large profits 5. Operations and accounting staff disagree about the costs of manufacturing and marketing products .

many of which are transaction based rather than product volume . 4. 2. It brings accuracy and reliability in product cost determination by focussing on cause and effect relationship in the cost incurrence When overheads constitute a large share of total costs. ABC uses multiple cost drivers. ABC provides more realistic product costs It identifies the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product. 3.Benefits of ABC Systems 1.

.Benefits of ABC Systems 5. ABC traces costs to areas of managerial responsibility. customers. besides the product costs It improves greatly the manager·s decision making as they can use more reliable product cost data. It provides cost driver rates and information on transaction volumes which are very useful to management for cost management and performance appraisal of responsibility centres. processes. 6. departments etc. 7.

assignment of common costs. . etc.Limitations 1. such as the chief executive's salary. It is a costly system to implement It may not be useful for small manufacturing firms especially where share of indirect costs in total cost is comparatively less. 2. 5. varying cost driver rates. 4. Even in activity-based costing. 3. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. some overhead costs are difficult to assign to products and customers. It can become complex due to numerous cost polls and multiple cost drivers Implementation of ABC system is difficult as to selection of cost drivers.

of purchase requisitions No. B and Z for which standard cost and quantities per unit are as follows: A Output (units) Direct material per unit Direct labour per unit Labour hours per unit Machine hours per unit No. Produces 3 products A. Ltd. of machine setups 10000 50 30 3 4 600 120 B 20000 40 40 4 4 900 130 Z 30000 32 48 5 7 1000 150 Case-1 .‡ ABZ Co.

total machine hours: 500000.Rs.1400000 Production scheduling/setup .2700000 Department X is labour intensive and Y is machine intensive. of batches for scheduling/setup-400 Required: Prepare cost statement under traditional absorption costing and activity based costing methods.1500000 Total Rs. Production overhead split by activity: Receiving and inspection -Rs. of batch received/inspected-2500 No. Total labour hours in Dept.1200000 Y: Rs. X: 200000.2700000 No. Also compare the result of the two methods and give your comments.‡ Production overheads split by department: X: Rs.Rs.1300000 Total . .

600000 350000 7500 12500 Case-2 Revenue Direct costs Production (units) Machine hours Inspection Rs.Chand and Co.. The firm assigns its Rs. a leading publisher.500000 of overheads to the two types of books. Some additional data follow: Paperback Hard bound Rs.1400000 Rs. Management is considering publishing only the higher quality book.1600000 Rs.200000 of utilities and Rs. One is paperback and the other is hardbound.‡ S.300000 of quality control inspectors· salaries. The overhead is composed of Rs.1250000 500000 42500 2500 . publishes two versions of a text book.

‡ Compute the overhead cost that should be allocated to each type of text book using cost drivers appropriate for each type of overhead cost ‡ Should the publisher stop producing the paperback books? Explain why management was considering this action and what should be the decision? .‡ Required: ‡ Compute the costs and profit when using absorption costing when machine hours was used to allocate overheads in the past.

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