Activity Based Costing

Direct and Indirect Cost

Direct

costs are transparent and how

they will be affected by decisions is
clearly observable
How indirect costs will be affected by
decisions is not clearly observable
Tendency to assume that these costs
are fixed and irrelevant in the short run

Long run

Overhead costs have escalated over the

years and they cannot be assumed to be
fixed and irrelevant for long run or strategic
decision making

ABC

During the 1980s the limitations of product

costing systems began to be widely
publicized
These systems were designed decades ago
when companies manufactured a narrow
range of products and direct labor and
materials were the dominant factory costs
Overheads were relatively small, Information
processing costs were high

ABC
Now

, wide range of products

Direct labor only a small fraction of total
costs
Overheads are of considerable
importance
Information processing are no longer a
barrier to introducing sophiscated cost
system

 Both

traditional and ABC systems

assign indirect costs to cost objects
In traditional system, overheads are
pooled by departments and are
allocated to products based on volume
related drivers such as labor hours or
machine hours

With ABC systems , first step is to identify

major activities of the organization
Costs are allocated to activity cost centres or
cost pools
Selecting appropriate cost drivers for
assigning the cost
Cost drivers includes non volume based
drivers such as number of production runs for
production scheduling
Assigning costs to products

Activity cost Drivers

Transaction

drivers such as number of

orders, number of inspections etc
Duration drivers such as setup time
Intensity drivers directly charge for the
resources consumed each time a
activity is performed

Activity hierarchy

Unit level Activities- Consume resources in

proportion to number of units produced
(Energy costs)
Batch related activities- Cost varies with
number of batches
Product sustaining activities- performed to
enable production and sale of individual
products (Cost of product enhancements,
technical support for individual products)
Facility sustaining- General administrative
support , property tax etc

Product Costs

In traditional system , product cost distortion

happens because
Unit level cost driver will not be able to assign
the costs of non unit- level activities
Product diversity with different consumption
ratios of resources
Traditional system may report fairly accurate
product cost for organizations with fairly
standardized product range or if indirect costs
are a low proportion of product cost

 ABC

system may be optimal when

there is intense competition
high proportion of indirect costs
product line complexity
Service companies are ideal candidates
for ABC since most of costs are fixed
and indirect

Cost Management Systems

The emphasis of a cost management system

is on the firms activities so much so that
CMS is synonymous, in certain respects, to
Activity Accounting or Activity-based
Costing (ABC).
Using ABC to improve the operations of an
organization is called activity-based
management or ABM

Objectives of Cost
Management System
6-7

Elimination of Non-Value-Added
Costs
Activities

Analysis and
Classification
Nonvalueadded
Activities

Valueadded
Activities

Reduce or
Eliminate

Continually Evaluate
and Improve

McGraw-Hill/Irwin

Just-in-Time Inventory and

Production Management
No materials are purchased and no products
are manufactured until they are needed.
The primary goal of a
JIT production system is
to reduce or eliminate
inventories at every
stage of production.

Key Features of the JIT

Approach
Smooth, uniform production rate
Pull method of production

Purchase is small lot sizes

Quick, inexpensive setups

High quality of materials

Effective preventive maintenance

Teamwork
Multiskilled workers

JIT Purchasing
Long-term
contracts with
suppliers.

Only a few
suppliers.

Grouped
payments to
vendor.

Minimal
inspection of
materials.

Parts delivered
in small lots.

Customer Profitability Analysis

Customer Profitability Analysis uses ABC to

determine activities, costs and profits
associated with serving particular customers
Profitable product but customer related costs
making certain customers unprofitable
Costly customer orders frequently,small
quantities, requires special packaging, faster
delivery, customized services