Session 7,8: MANAGERIAL ACCOUNTING

(AC5203)

Athira Prabhakar
Telephone: 9567560296
E-mail: athira_vf@thapar.edu
Alternative e-mail ID: athiprabhakar@gmail.com
 Chapter 5

ACTIVITY-BASED COSTING AND

ACTIVITY-BASED MANAGEMENT
 Background

• Recall that Factory Overhead is applied to production in a rational systematic manner, using
some type of averaging. There are a variety of methods to accomplish this goal.

• These methods often involve tradeoffs between simplicity and realism

Simple Methods Complex Methods

Unrealistic Realistic
Plant wide & Department Overhead Calculations

•Plantwide Overhead Rate:

•Total Estimated Overhead ** / Total Estimated Base ***
** Obtain total of all overhead costs to be allocated.
*** Determine the best “base” – direct labor hours, machine hours, etc.
•This rate is used to allocate overhead costs to all products
•Department Overhead Rate: Similar concept except overhead cost pools and selected base are
obtained by department rather than plantwide.
 Example Of Plantwide & Department Overhead
Calculations

•For our example, let’s say we have two departments, A and B with overhead costs of $300,000 and
$450,000, respectively.
•The best base (the most likely cost driver) in
• Department A is Direct Labor Hours and
• Machine Hours in Department B.

•Machine hours in Dpt A=750 and Dpt B=1200

•Labor hours in Dpt A=8000 and Dpt B=7000
Plant wide Overhead Calculations
Plantwide
Overhead 750000
DLH 15000
MH 1950
Allocation rate-DLH 50
Allocation rate-MH 384.6154
Departmental Overhead Calculations
Dept A Dept B Plantwide
Overhead 300000 450000 750000
DLH 8000 7000 15000
MH 750 1200 1950
Allocation rate-DLH 37.5 50
Allocation rate-MH 375 384.6154
 Broad Averaging

• Historically, firms produced a limited variety of goods while their indirect costs were relatively
small.

• Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of
how they are actually incurred
• Peanut-butter Costing

• The end result: over costing and under costing

• Over costing – a product consumes a low level of resources but is allocated high costs per unit

• Under costing – a product consumes a high level of resources but is allocated low costs per unit
 Broad Averaging

•When costs are averaged across all four diners, both Emma and Matthew are over-costed (the cost
allocated to them is higher than their individual cost), James is under-costed (the cost allocated to him is
lower than his individual cost), and Jessica is (by coincidence) accurately costed.
 Cross-subsidization
• The results of overcosting one product and undercosting another.

• The overcosted product absorbs too much cost, making it seem less profitable than it really is

• The undercosted product is left with too little cost, making it seem more profitable than it really is

Emma James Jessica Mathew Total Average

Entrée 11 20 15 14 60 15
Desserts 0 8 4 4 16 4
Drinks 4 14 8 6 32 8
Total 15 42 27 24 108 27

Under/Over -12 15 0 -3
 An Example: Plastim (Illustration 1.2)

∙ Plastim produces two types of metal lenses (simple lense-S3 and Complex lens-C5). Plastim
manufactures 60,000 S3 and 15,000 C5. Its simple costing system uses a single indirect-cost pool and
allocates costs to the two lenses on the basis of direct manufacturing labor hours. It provides the
following budgeted cost information:

∙ Plastim’s managers budget 30,000 total direct manufacturing labor hours to make the 60,000 S3 lenses
and 9,750 total direct manufacturing labor hours to make the 15,000 C5 lenses.

∙ Total indirect cost 2115000

∙ Direct labor hours: 30,000 for S3 and 9750 hours for C5.
∙ Direct material cost 18.75/simple lens and 45/per complex lens
∙ Direct mold cleaning charge 2/simple lens and 10/per complex lens
∙ Direct labor cost 10/simple lens and 13/complex lens
 Plastim and Simple Costing
Direct cost
What is the total direct cost of the sample lens and complex lens?
Plastim and Simple Costing
Direct cost
Plastim and Simple Costing
Direct cost
Plastim and Simple Costing
Indirect cost
Illustration 1.3
 Steps of ABC costing

• Step 1: Identify the Products that are the chosen Cost Objects.
• Step 2: Identify the Direct Costs of the Products
• Step 3: Select the Activities and Cost-Allocation Bases to Use for Allocating Indirect Costs to the
Products
• Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base
• Step 5: Compute the Rate per Unit of Each Cost-Allocation Base
• Step 6: Compute the Indirect Costs Allocated to the Products.
Illustration 1.4
Plastim and ABC Rate Calculation
Plastim and ABC Product Costs
Plastim: Simple and ABC Compared
Illustration 1.5
Illustration 1.6
 Conclusions

• Each method is mathematically correct

• Each method is acceptable

• Each method yields a different cost figure, which will lead to different Gross Margin
calculations

• Only Overhead is involved. Total Costs for the entire firm remain the same – they
are just allocated to different cost objects within the firm

• Selection of the appropriate method and drivers should be based on experience,

industry practices, as well as a cost-benefit analysis of each option under
consideration
Rationale for Selecting a More Refined Costing System

• Increase in product diversity

• Increase in Indirect Costs

• Advances in information technology

• Competition in foreign markets

 Cost Hierarchies

• ABC uses a four-level cost structure to determine how far down the production
cycle costs should be pushed:
• Unit-level (output-level)
• Batch-level
• Product-sustaining-level
• Facility-sustaining-level
 ABC versus Simple Costing Schemes

• ABC is generally perceived to produce superior costing figures due to the use of
multiple drivers across multiple levels

• ABC is only as good as the drivers selected, and their actual relationship to costs.
Poorly chosen drivers will produce inaccurate costs, even with ABC
 Activity-Based Management

• A method of management that used ABC as an integral part in critical

decision-making situations, including:
• Pricing & product-mix decisions
• Cost reduction & process improvement decisions
• Design decisions
• Planning & managing activities
Signals that Suggest that ABC Implementation Could Help a
Firm:

• Significant overhead costs allocated using one or two cost pools

• Most or all overhead is considered unit-level

• Products that consume different amounts of resources

• Products that a firm should successfully make and sell consistently show small
profits

• Operations staff disagreeing with accounting over manufacturing and marketing

costs
 ABC and Service / Merchandising Firms

• ABC implementation is widespread in a variety of applications outside

manufacturing, including:
• Health Care
• Banking
• Telecommunications
• Retailing
• Transportation
Illustration 1.7
Illustration 1.6
Illustration 1.7
Illustration 1.7
Illustration 1.7
Illustration 1.6
Illustration 1.6
Thank You!