Activity Based Costing

By
PL.Subramanian
25270452
9821807128
plsubr@gmail.com
 Activity Based Costing
 Background: Companies (Television and
automobile manufacturers) produced a limited
variety of products. Indirect or overhead costs were
a relatively small percentage of total costs. Using
simple costing systems to allocate costs broadly
was easy, inexpensive, and relatively accurate.
 Now product diversity and indirect costs have
increased, broad averaging has resulted in grater
inaccuracy of product costs.
 The use of a single, plant-wide manufacturing
overhead rate to allocate costs to products often
produces unreliable cost data,
 Activity Based Costing
 Background:
 The peanut-butter costing describes a
particular costing approach that uses
broad average for assigning the cost of
resources uniformly to costs object when
the individual products may in fact use
those resources in non-uniform ways.
 Activity Based Costing
 Product under costing: A product consumes a
high level of resources but is reported to have a
low cost per unit.
 Product over costing: A product consumes a low
level of resources but is reported to have a high
cost per unit.
 Product cost cross subsidisation: It means that if a
company under costs one of its products, then it
will cover cost at least one of its other products.
Likewise if it overcosts one od its products, it
will under costs at least one of its other products.
 Plastim Corporation
 Plastim Corporation manufactures lenses
for the rear taillights of automobiles.
 Manufacturing Process: a lens, made from
black, red, orange, or white plastic, is the
part of the lamp visible on the
automobile’s exterior. Lenses are made
by injecting molten plastic into a mold to
give the lamp its desired shape. The mold
is cooled to allow plastic to solidify, and
the lens is removed.
 Plastim Corporation
 It manufactures two lens – CL –Complex
lens and S –simple lens and supplies to a
major automobile manufacturer under a
contract.
 Plastim Corporation
 Sequences of processes involved:
 Design products and processes.
 Manufacture lenses
 Distribute lenses.
 Plastim Corporation
 It is operating at capacity and incurs very
low marketing costs. It has minimal
customer service costs.Its business
environment is very competitive with
respect to simple lenses.
 It sells S at $63 and CL at $137
 Plastim Corporation
 Competitor has offered to sell S at $53.It
has the following options:
 It give up the business in S if it is
unprofitable.
 It can reduce the price and either accepts
lower margin or aggressively seek to
reduce costs.
 Plastim Corporation
Cost Sheet
Simple Lens Complex Lens
60000 Units 15000 Units
Direct Materials 1125000 675000
Direct m Labour 600000 195000
Total direct cost 1725000 870000
Indirect Costs 1800000 585000
Total Costs 3525000 1455000
 Plastim Corporation
 Cost per unit: S= 58.75 and CL = 97
 Refining Costing System
 Refining Costing System: It reduces the use of
broad averages for assigning the cost of
resources to cost objects and provides better
measurement of the costs of indirect resources
used by different cost objects.Refining costing
system required due to:
 Increase in product diversity
 Increase in indirect costs
 Competition in product markets.
 Refining Costing System
 Refining Costing System:Methods to be followed:
 Direct Cost Tracing: Identify as many direct costs
as is economically feasible.
 Indirect Cost Pools: Expand the number of indirect
cost pools until each of these pools is more
homogenous. In a homogenous cost pool, all of the
costs have the same or a similar cause and effect
relationship with a single cost driver that is used as
the cost allocation base.
 Cost Allocation Base: Use the cost driver as the
cost allocation base for each homogenous indirect
cost pool
 Cost Hierarchies
 Cost Hierarchy:It categorises various activity
cost pools on the basis of the different types of
cost drivers or cost allocation bases or different
degrees of difficulty in determining cause and
effects (or benefits received) relationships.
 ABC system commonly use a cost hierarchy
having four levels:
 Output unit level costs
 Batch level costs
 Product sustaining costs
 Facility sustaining costs.
 Cost Hierarchies
 Output unit level costs: Output unit level costs
are the costs of activities performed on each
individual unit of a product or service.Example-
Machine operations costs (energy, machine
depreciation and repair) related to the activity of
running the machines
 Batch level costs: Batch level the costs of
activities related to a group of units of products
than to each individual unit of product. Example:
Set up costs. Set up costs not on the number of
units produced but on the number of set up.
 Cost Hierarchies
 Product sustaining costs: Are the costs of
activities undertaken to support individual
products regardless of the number of units or
batches in which the units are produced.
Example- Design costs.
 Facility sustaining costs: Are the costs of
activities that cannot be traced to individual
products but that support the organisation as a
whole. Example – General administration costs
including top management compensation, rent
and building security etc.
 Implementing ABC
 Steps involved in implementing ABC:
 Identify the Products that are the Chosen Cost Objects.
 Identify the Direct Costs of the Products.
 Select the Activities and Cost Allocation Bases to Use for
Allocating Indirect Costs to 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 the Total Cost of the Products by adding All Direct
and Indirect Costs Assigned to the Products.
 Plastim’s Indirect Costs
Indirect Costs
BQ of Cost Allocation base
Activity Costs Rate
Design- PS 450000 100 parts SQ.Ft 4500
Setup molding 300000 Setup H 2000
machines –BL
Machine Operations 637500 MMH 12750
OUL
Shipment setup BL 81000 Shipment 200
Distribution OUL 391500 Cubic ft 67500
Admin FS 255000 DMLH 39750
 Plastim’s Indirect Costs
Indirect Costs
Activity Cause –Effect Relationship

Design- PS Costs increase with more complex mold

Setup molding machines –BL Increase with setup hours

Machine Operations OUL Increases with molding machine hours

Shipment setup BL Changes with no of shipments

Distribution OUL Changes with cubic feet of packages delivered

Admin FS Increases with direct manufacturing labour hours

 Plastim’s Cost Sheet
Cost Sheet
SL CL Total
Direct Materials 1125000 675000 1800000

Direct Manufacturing Labour 600000 195000 795000

Direct Mold cleaning and 120000 150000 270000

maintenance costs
Total direct Costs 184500 1020000 2865000

Design 135000 315000 450000

Setup of molding machines 75000 225000 300000

Machine Operation 450000 187500 637500

 Plastim’s Cost Sheet
Cost Sheet
SL CL Total
Shipment setup 40500 40500 81000

Distribution 261000 130500 391500

Administration 192453 62547 255000

Total Indirect Costs 153953 961047 211500

Total Costs 2998953 1981047 4980000

Cost of SL = 2998953/60000 = 49.98

Cost of CL = 1981047/15000 = 132.07

 Activity Based Costing
 Managers choose the level of detail to use in a
costing system by evaluating the expected costs of
the system against the expected benefits that will
come from using it to make better decision. In the
following cases ABC will be beneficial:
 Sales are increasing, but profits are declining.
 Line managers suggest that apparently profitable
products be dropped.
 Marketing or production managers are using
“bootleg costing systems”, which are informal
systems they designed, often on a personal
computer.
 Activity Based Costing
 Indicators for ABC:
 Some products that have reported high
profit margins are not sold by
competitors.
 The firm seems to have capture a highly
profitable product niche all for itself.
 Overhead rates are very high and
increasing over time.
 Products lines are diverse.
 Activity Based Costing
 Indicators for ABC:
 Direct labour is a small percentage of total
costs.
 The results of bids are difficult to explain.
 Competitors high volume products seem to be
priced unrealistically low.
 The accounting department spends significant
amounts of time on special costing projects to
support bids or pricing decisions.
 Activity Based Costing
 Indicators for ABC:
 Direct labour is a small percentage of total
costs.
 The results of bids are difficult to explain.
 Competitors high volume products seem to be
priced unrealistically low.
 The accounting department spends significant
amounts of time on special costing projects to
support bids or pricing decisions.
 Just in time Inventory
 A cost management tool that is widely
used in manufacturing is the just in time
system. A JIT inventory and production
management system is a comprehensive
inventory and production management
system is a comprehensive inventory and
manufacturing control system in which no
materials are purchased and no products
are manufactured until they are needed.
 Just in time Inventory
 A primary goal of a JIT production
system is to reduce or eliminate
inventories at every stage of production,
from raw materials to finished goods.
 Just in time Inventory
 Key Features of JIT Approach:
i. A smooth uniform production rate: An important goal of
a JIT system is to establish a smooth production flow,
beginning with the arrival of materials from suppliers
and ending with the delivery of goods to customes.
ii. A pull method of coordinating in the production
process: Under the pull method, goods are produced in
each manufacturing stage only as they are needed at the
next stage.
iii. Purchase of materials and manufacture of subassemblies
and product in small lot sizes: This is due to the pull
method of production planning.
 Just in time Inventory
 Key Features of JIT Approach:
iv. Quick and inexpensive setups of production machinery:
In order to produce in small lot sizes, a manufacturer
must be able to set up production runs quickly.
v. High quality levels for raw material and finished
products: If raw materials and parts are to arrive ‘just in
time’ for production, they must be ‘just right’ for their
intended purpose and if very small stocks of finished
goods are to be maintained, then finished products must
be of uniform high quality. A Total Quality Control
(TQC) program often accompanies a just in time
production environment.
 Just in time Inventory
 Key Features of JIT Approach:
vi. Effective preventive maintenance of
equipment.
vii. An atmosphere of teamwork to improve
the production system
viii.Multiskilled workers and flexible
facilities: Manufacturing equipment must
be flexible enough to produce a variety of
components and products.
 Just in time Inventory
 Just in Purchasing: Along with a JIT
production approach, many companies
implement JIT purchasing. Materials and
parts are purchased from outside vendors
only as they are needed. This avoids the
costly and wasteful buildup of raw
material inventories.
 Just in time Inventory
 Key Features of JIT Purchasing:
i. Only few suppliers.
ii. Long term contracts negotiated with
suppliers.
iii. Materials delivered in small lots
immediately before they are need.
iv. Only minimal inspection of delivered
materials.
v. Grouped payments to each vendors
 Just in time Inventory
 Example: CD World is purchasing from
Sontek Compact diskes. Previously
Sontek was delivering 1000 packages 13
times per year. After CD world has gone
Jit, now Sontek delivers 100 packages of
disk 130 times per year (5 times every 2
weeks). For this it would increase the
price by $0.02