CHAPTER 5

Activity-Based Costing and Activity-Based Management

COURSE OBJECTIVES
To understand the link between costs and changes in volumes and profitability To explain the use and demonstrate the analysis of management accounting information for managerial decision making. To explain the application of financial and operational measures for managerial decision making and performance evaluation

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

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

The end-result: overcosting & undercosting

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

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

An Example: Plastim

Plastim & Simple Costing

The Problem of Using Only Measures of Production Volume to Allocate Overhead

1. Traditionally firms use labour hours or machine hours as allocation bases for assigning overhead to products. 2. This assumes that all costs are proportional to production volume. 3. Setup costs are not proportional. 4. For example, a setup might work for a 400,000 unit production run just as well as a 200,000 production run. 5. Low-volume items are undercosted and high-volume items are overcosted.

Plastim and ABC Illustrated

 An activity is an event, task or unit of work with a specified purpose. Eg Designing products, setting up of machines, operating machines, distributing products, etc. Activities are usually verbs- things a firm does.

Activities and Cost drivers

Examples of Activities
1. Processing purchase orders. 2. Handling materials and parts. 3. Inspecting incoming material and parts. 4. Setting up equipment. 5. Producing goods using manufacturing equipment. 6. Supervising assembly workers. 7. Inspecting finished goods. 8. Packing customer orders.

Examples of Cost Drivers

1. Number of purchase orders processed. 2. Number of material requisitions. 3. Number of receipts. 4. Number of setups. 5. Number of machine hours. 6. Number of assembly labor hours. 7. Number of inspections. 8. Number of boxes shipped.

Examples of Associated Costs

1. Various labor costs. 2. Depreciation. 3. Electricity costs

Major Activities

Associated Costs

Cost Driver

Processing purchase Labour costs for workers determining order for materials and order quantities, contacting vendors, parts and preparing purchase orders

Number of purchase orders processes

Handling material and parts

Labour costs for workers handling material and parts, depreciation of equipment used to move material and parts

Number of material requisitions

Inspecting incoming material and parts

Labour costs for workers performing inspections, depreciation of equipment used to test strength of materials, tolerances, etc.

Number of receipts

Setting up equipment

Labour costs for workers involved in setups, depreciation of equipment used to adjust equipment

Number of setups

Major Activities

Associated Costs

Cost Driver

Producing goods using Depreciation on manufacturing manufacturing equipment equipment Salary of assembly supervisors

Number of machine-hours

Supervising assembly

Number of assembly labour-hours

Labour cost for finished goods inspections, Workers Inspecting depreciation of equipment finished goods used to test whether finished goods meet customer specifications, etc.

Number of inspections

Packing customer orders

Labour cost for packing workers, cost of packing materials, etc.

No. of boxes packed

The ABC Approach

1. Identify the major activities that cause overhead costs to be incurred. 2. Group costs of activities into cost pools. 3. Identify measures of activities (the cost drivers) 4. Relate costs to products using the cost drivers.

Plastim and ABC Rate Calculation

Plastim and ABC Product Costs

Plastim: Simple & ABC Compared

 A company produces two products, A and B, and estimates that its overhead costs will be Rs. 2,61,780. Overhead has traditionally been allocated on the basis of direct labor hours. Estimated data follow:
Product A 500 units 1 Product B 1,250 units 2

Estimated volume Direct labor hours per unit

Activity Centers Machine setups Maintenance Inspections

Estimated Cost 27,140 183,040 51,600 Rs. 261,780

Estimated Activity Product A Product B 20 (nos) 26 1,620 (Sqft.) 2,540 56 (nos.) 288

Solution
Activity centre rates:
Setups Maintenance Inspections 27,140/46 = 590 / setup 183,040/4,160 = 44/sq. ft. 51,600/344 = 150/inspection
TC 87.26 174.52 ABC 182.96 136.24

Overhead absorption rate:

Product A Product B

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

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.

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)-activities performed for each unit of production- machine op costs Batch-level- activities performed for each batch of unitsmachine set up Product- sustaining-level-activities to support products irrespective of nos. produced- designing Facility-sustaining-level-support organization as a wholeCEO salary

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

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

 SBI earns interest spread of 3 percent on average deposits Depositors with less than Rs. 1000 balance pay penalty of Rs. 20 per month. Assume Arvinder always has an average balance < 1000
particulars Dep/wd with teller Dep/wd with ATM AB Cost per Nitin trans. 2.50 0.80 40 10 Arvinder 50 20 Sanjay 5 16

Other dep/wd
Cheques FC drafts Inquiries Avg premier account balance

0.50
8 12 1.5

0
9 4 10 1100

12
3 1 18 800

60
2 6 9 25000