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Activity-Based Costing and Activity-Based Management

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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 Unrealistic Complex Methods Realistic

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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: overcosting & undercosting

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Over & Undercosting


Overcosting a product consumes a low level of

resources but is allocated high costs per unit Undercosting a product consumes a high level of resources but is allocated low costs per unit

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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

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Case facts
Plastim corp manufactures lenses for rear tail lights of

automobiles. Under its contract with Tata motors Produces 2 types, a complex lens CL5 and a simple lensS3. Compex lens has special features in contrast to the simple lens Operates at capacity and has low marketing costs and mini. customer servicing cost. Business environment very competitive with respect to simple lens New supplier, Jain Motors who offers to supply S3 Lens at Rs.53 well below Plastims price of Rs.63. Fortunately ,Same comp pressures do not exist for the complex lens priced at Rs.132 per lens.
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CL5 15,000 UNITS AND S3 60,000 UNITS


30,000 DIRECT manufacturing hours used to

manufacture 60,000 units of S3 and 9750 hours used to manufacture CL5

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Decision Dilemma for Plastim


Plastims mgt has various options available to it : Plastim can give up the Tata business in simple lenses if it is unprofitable .Jain motors makes only simple lenses and perhaps, therefore, uses simpler technology and processes than Plastim, which makes both simple and complex lenses .The simpler operations may give Jain motors a cost advantage that Plastim cant match.If so it is better for Plastim to not supply S3 lens to Tata. Plastim can reduce the price of simple lens and either accept a lower margin or aggressively seek to reduce cost 2009 Pearson Prentice Hall. All rights reserved.

Simple costing system using a single Indirect cost Pool used by Plastim
1.Identify the products that are chosen Cost objects-

60,000 simple S3lenses & 15,000 complex CL5 2.Identify the Direct cost of the products 3.Select the cost allocation bases to use for allocating Indirect costs to the products Plastim uses direct Manufacturing labor hours as the only allocation bases to allocate all the manufacturing & non manufacturing indirect costs to S3 & CL5. 4.Identify the indirect costs associated with each cost allocation base 5.Compute the indirect costs allocated to the products. 6.Compute total cost of the products by adding all 2009 Pearson Prentice Hall. All rights reserved. direct and indirect costs.

4.Identify the indirect costs associated with each cost allocation base
Compute the rate per unit of each cost-Allocation Base: Budgeted Indirect-Cost Rate = Budgeted TCs in Indirect Pool/Budgeted total quantity of cost allocation base =23,85,000/39,750 =Rs 60 per direct manufacturing labour hours

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An Example: Plastim

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Plastim & Simple Costing

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The mgt team identifies the foll 7 activities by developing a flowchart of all the steps & processes needed to design ,manufacture, distribute S3 & CL5

Design products & processes.


Set up molding machines to ensures that the molds are

properly held in place and parts are properly aligned before manufacturing starts. Operate molding machines to manufacture lenses Clean & maintain the molds after lenses are manufactured- Identified as direct cost Prepare batches of finished lenses for shipment Distribute lenses to customers Administer and manage all processes at Plastim
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Implementing ABC at Plastim


Identify the products that are chosen as cost objects

Identify the direct costs of the products


Select the activities and the cost allocation bases to use

for allocating indirect costs to the products Identify the indirect costs associated with each cost allocation base Compute the rate per unit of each cost allocation base Compute the indirect costs allocated to the products Compute total costs of the products by adding all direct and indirect costs assigned to the products.
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Plastim and ABC Illustrated

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Cost Hierarchies- categorises various activity cost pools on the basis of


the different types of the cost drivers, or cost allocation bases ,or different degrees of difficulty in determining cause & effect relationships.

Output-unit level costs are the costs of activities

performed on each individual unit of a product or service. Eg:Machine operations cost Batch Level costs are the cost of activities related to a group of units of products or services rather than to individual unit of product or service. Eg: Setup costs Product Sustaining Costs are the costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced.
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Eg: Design Costs, Product research & development

costs, marketing costs to launch new products. Facility Sustaining costs are the costs of activities that cannot be traced to individual products or services but that support the organization as a whole.Eg:General Administration costs(including top mgt compensation, rent and building security)

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Plastim and ABC Rate Calculation

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Plastim and ABC Product Costs

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Plastim: Simple & ABC Compared

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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 costbenefit analysis of each option under consideration

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A Cautionary Tale
A number of critical decisions can be made using this

information;
Should one product be pushed over another? Should one product be dropped?

Accounting for overhead costs is an imprecise science.

Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.

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Rationale for selecting a more refined costing system


Increase in product diversity
Increase in Indirect Costs Advances in information technology

Competition in foreign markets

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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

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ABC vs. 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

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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

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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
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ABC and Service / Merchandising Firms


ABC implementation is widespread in a variety of

applications outside manufacturing, including:


Health Care Banking Telecommunications Retailing Transportation

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