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Activity-Based Costing

Minimizes cross-subsidization among


products.
Recognizes that complexity is the single
largest driver of cost.
Utilizes more service center cost pools (called
activities or activity centers).
Utilizes more cost drivers (i.e., unit-level,
batch-level and product-level).

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Activity-Based Costing
Each activity is allocated based on the cost
driver determined to be most appropriate
for that pool of costs.
Activitys costs may be assigned directly to
product (rather than through a production
cost center).
Pitfall? Increased recordkeeping.
Time-based activity-based costing.
Focuses on amount of time spent in performing
activities.

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Activity-Based Costing
Examples of cost drivers used:
Unit level drivers.
E.g., number of units, direct labor hours, direct labor
dollars, machine hours.
Costs per unit stay the same regardless of number of
units.
Batch level drivers.
E.g., number of orders processed, number of production
batches run.
The larger the production run or order, the lower the
costs per unit.
Product level drivers
Costs required to design or maintain products.
Are assigned based on number of products. 18-3
Common Activities and associated cost drivers

Major Activities Associated Costs Cost Driver


(1)c (2) (3)
Processing purchase online for Labour costs for workers Number of purchase order
materials and parts deter-mining order quantities, processed
contact-ing vendors, and
preparing purchase order
Handling material and parts Labour costs for workers Number of material
handling material and parts, requisitions
depreciation of equipment
used to move material and
parts
Inspecting incoming material Labour costs for workers Number of receipts
and parts performing inspections,
depreciation of equipment
used to test strength of
materials, tolerances, etc.
Continue 1-4
Common Activities and associated cost drivers

Major Activities Associated Costs Cost Driver


(1) (2) (3)
Setting up equipment Labour costs for workers Number of setups
involved in setups,
depreciation of equipment
used to adjust equipment

Producing goods using Depreciation on Number of machine-hours


manufacturing equipment manufacturing equipment

Supervising assembly workers Labour cost for finished goods Number of assembly labour
inspecting finished goods inspections, depreciation of hours number of inspections
equipment used to test
whether finished goods meet
customer specifications etc.

Packing customer orders Labour cost for packing Number of boxes packed
workers cost of packing
materials, etc.
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Illustration 1
Costs relating to set-ups 35%
Costs relating to materials handling 15
Costs relating to inspection 50
Total production overhead 100
The following total activity volumes are associated with each product line for the period as a whole:
No. of No. of movement No. of
Set ups of materials Inspections
Product D 75 12 150
Product C 115 21 180
Product P 480 87 670
670 120 1,000
Required :Identify the cost drivers for each of the cost categories above.

Category Driver
Set up costs Number of set ups
Materials handling costs Material movements
Inspection costs Number of inspection
Illustration 2
Total Overheads 100,000
Costs relating to set ups 50%
Costs relating to inspections 50%
Number of Set ups 100
Number of Inspections 50
Required: Calculate the Cost per Driver.

Solution Step 1 - Pool the costs


Category Working Pool
Set up costs (100,000 x 50%) 50,000
Inspection costs (100,000 x 50%) 50,000
TOTAL OVERHEAD (Check) 100,000

Step 1 Divide by number of drivers


Category Number of Cost Pool Working Cost per
Drivers` Driver
Set up costs 100 50,000 (50,000 / 100) 500
Inspection costs 50 50,000 (50,000 / 100) 1000
Illustration 3
To produce product A takes the following:
Number of set ups 20
Number of inspections 2
Using the cost per driver in the previous example, what are the total overheads
applicable to product A?
Solution
Driver Number Cost Per Driver Total Cost
Set ups 20 500 10,000
Inspections 2 1000 2,000
Total Overhead Per Unit of A 12,000
Illustration 4
Company A has the following information applicable to its products:
Total Overheads = 100,000
Total machine Hours = 50,000
Product A B
Units of Production 2,500 5,000
Material Cost p/unit 30 50
Labour Cost per unit 20 16
Machine Hrs P/unit 10 5
% Overheads
Set up Costs 35
Inspections 45
Materials Handling 20
A B Total
Set ups 300 50 350
Inspections 500 250 750
Goods Movements 300 700 1000
What is the Cost per unit of A and B
(1) Under Traditional Absorption Costing.
(2) Under ABC.
SOLUTION Absorption Rate Calculation
Total Overheads Machine Hours Absorption Rate
100,000 50,000 2
The absorption rate to absorb overheads $2 per machine hours

Cost of unit under Absorption Costing


Item Working A B
Allocated Overhead (hrs p/unit x $2) 20 10
Material cost per unit 30 50
Labour cost per unit 20 16
Total cost per unit 70 76

ABC Cost Per Unit


Cost Per Driver
Category Cost Pool No.Drivers Cost per Driver
Set up costs 35,000 350 100
Inspections 45,000 750 60
Materials haldling 20,000 1,000 20
Total Overhead 100,000
Cost Per Unit of each Product
Driver Working Product A Working Product B
Set up Costs 300 x 100 30,000 50x 100 5,000
Inspections 500 x 60 30,000 250 x 60 15,000
Movements 300x 20 6,000 700 x 20 14,000
Total Overhead 66,000 34,000
Total Production 2,500 5,000

Overhead Per Unit 26.4 6.8


Materials Cost per Unit 30 50
Labour cost per unit 20 16
76.4 72.8

COMPARISON
Cost per Unit Product A Product B
Absorption Costing $70 $76
ABC $76.4 $72.8
ABC for marketing selling and distribution expenses

Traditional costing Based customer profitability analysis


Particular Simple Complex
Sales revenue Rs.12,80,000 Rs.12,80,000
Costs of goods sold 6,16,000 6,24,000
Gross margin 6,64,000 6,36,000
Marketing, selling , distribution and administrative expenses (033 x sales) 4,22,000 4,15,000
Operating profit 2,41,600 2,20,200
Profit ( as percentage of sale) 18.8 17.5
Identification of activities and cost drivers

Activity Activity Cost Driver


1 Marketing and technical support 1 Estimated propeortion of time spent on each customer
2 Travel to customers 2 Actual expenditure
3 Distribution of sales catalogue 3 Number of mailings
4 Servicing of customers 4 Estimated proportion of time spent on each customer and
supplies used by them
5 Handle customer orders 5 Number of orders
6 Warehouse inventory for customers 6 Quality of inventory and space required by customer
7 Shipping dispatch to customers 7 Actual records
Identify resource spending
Activity Simple Complex
1. Marketing and technical support Rs.28,000 Rs.2,16,000
2. Travel to ccustomers 4,800 28,800
3. Distribution of sales catalogue 400 400
4. Servicing of customers 16,000 1,68,000
5. Handling customer orders 2,000 72,000
6. Warehouse inventory 3,200 35,200
7. ship/dispatch to customers 50,400 168,000
Total activity expenses 1,04,800 6,88,400
Activity based costing customer profitability analysis
Particulars Simple Complex
Sales revenue Rs.12,80,000 Rs.12,60,000
Cost of goods sold 6,16,000 6,24,000
Gross margin 6,64,000 6,36,000
Marketing, selling and distribution expenses:
Marketing and technical support 28,000 2,16,000
Travel to customers 4,800 28,000
Distribution of sales catalogue 400 400
Servicing of customers 16,000 1,68,000
Handling customer orders 2,000 72,000
Warehouse inventory 3,200 35,000
Ship/dispatch to customers 50,400 1,68,000
Total activity expenses 1,04,800 6,88,400
Operating profit 5,59,200 (-52,400)
Profits as percentage of sales (operating margin) 43.7 (-4.2)
Activity-Based Management
Supported by activity-based costing.
Purpose is to focus company on finding more
profitable businesses or finding ways to
perform tasks better, faster, and cheaper.
May involve:

Total quality management.


Quality function deployment.
Process improvement.
Reengineering.
Elimination of non-value-added activities.
18-16
SUMMARY
The traditional costing system (TCS) Assigns indirect costs/overheads to job/products in two stages: first, the accumulated cost are allocated to
production departments (cost centers), second, the accumulated costs in cost centers are assigned to individual job/products on the basis of
an overhead allocation rate based on/ in proportion to some measure of volume of production such as direct labour cost, direct labour-hour
rate, machine hour rate and so on. It has the merit of being simple, easy to use and understand, and applied consistently from year to year. It is
adequate for financial reporting of inventory valuation.
It has, however, serious limitations/inadequacies due to its assumption that all overhead are proportionate to value of production, many
overheads costs are, actually, not proportionate to volume. Examples of such costs are setup costs of machines/equipment, cost of
inspection/handling of materials and so on. They are affected by complexity rather than volume. As a result simple high-volume products
would be over costed (i.e receive a larger allocation of overheads) and low-volume complex products would be undercosted ( i.e receive a
smaller allocation of overheads). The use of volume-related allocation base of TCS for allocating overhead would result in product cost
distortion in an environment of complex and high product variety. The ABC system eliminates this source of cost distortion.
The ABC system also uses a two-stage overhead allocation: (i) tracing costs to activities and (ii) tracing costs from activities to products/jobs.
The first step is to identify major activities that cause/drive overhead costs to be incurred. Some of the activities are related to production
volume (such as production runs, salary of supervisors and so on ) but others are not (such as inspection/handling of materials, setting up
equipment and so on ) the cost of resources consumed in performing these activities are grouped into cost pools.
The next step is to assign costs to products/jobs using cost drivers as a measure of activity. Cost drivers represent the quantity of activities used
to produce individual products. They identify the linkage between activities and cost objects and serve as quantitative measures of the output
of activities. In fact, they are the central innovation of ABC system. A firm can choose from three types of cost drivers: (I) transaction (II)
duration and (III) intensity (direct charging )
Transaction cost drivers are used to count the frequency of an activity/number of times an activity is performed. It is the least expensive as
well as the least accurate. Duration drivers represent the amount of time required to perform an activity (e.g. inspection-hour). They are more
accurate then transition drivers, but more expensive to implement. Intensity drivers are used to charge directly for the resources used each
time an activity is performed. They are the most accurate but the most expensive to implement. The choice of an appropriate activity cost
driver involves balancing the benefits of increased accuracy against the cost of increased measurement.
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The activity costs are assigned to individual jobs/products on the basis of activity cost driver rate ( ACDR). The ACDR= activity expenses 4 total
quantity of the activity cost driver. The activity expenses assigned to a product = ACDR 3 quantity of each activity cost driver used by the
product concerned.
The activity-based management (ABM) refers to a set of actions that management can take, based on information from an ABC study, to
increase/improve profitability. These include a combination of (i) repricing of unprofitable products (ii) increasing sales volume of highly
profitable products (iii) process improvement (e.g how to reduce setup times in contrast to faster run of production, equipment and (iv)
engineering and design improvements. Their combined effect would be production of the same volume and mix of products with fewer
resources.
Practical capacity is a better measure of cost of resources to handle each production (i.e capacity expenses 4 practical capacity). It is the
maximum amount of work that can be performed by resources supplied for production/services and is expressed as a percentage of
theoretical capacity. Theoretical capacity means the normal working hours of a machine/ working employee. The difference between
theoretical capacity and practical capacity is the time utilized by the employees for breaks, arrivals, departures and so on, which are not
related to actual work performance. It may also represent allowances for downtimes of machines due to maintenance, repair and rescheduling
fluctuations and so on. The expenses of resources unused during the production (difference between theoretical capacity and practical
capacity) is the cost of unused capacity. Such a cost should be assigned to the person/customer/department/market segment concerned
with/responsible for it.
Marketing, selling and distribution expenses are significant components of overhead costs of companies. Most of these costs are associated
with customers, market segments and distribution channels rather than to individual products. The ABC is applicable to such costs also. Tis
focus is on tracing these costs to customer segments. The activity to individual customers. The resource spending in the various customer
accounts are then identified. The final stage is preparation of customer profitability analysis.
The ABC customer profitability analysis can be used to manage its profitable and unprofitable customers. To protect them from competitive
inroads profitable customers may be offered discounts/ incentives and special services to retain them. The unprofitable customers can be
transformed into profitable customers through a number of actions: (I) process improvement, (II) activity-based pricing and (III) managing
customer relationships.

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The ABC system is as much applicable to service companies as it is to a manufacturing company. Service companies have a unique cost
structure. Virtually all their costs are indirect/fixed. In contrast to manufacturing companies, customer behavior determines the basic
operating costs of products/services of service companies. They should, therefore identify the differential profitability of individual customers
as they determine the quantity of demands for their operating activities. Moreover service companies should act on total relationship
profitability of a customer and not on the profitability of just a single customer. The structure/ construction of the ABC system of a service
company is identical to that of a manufacturing company.
The ABC system has advantage as well as limitations. Its major benefits are: (i) it does not under -cost complex low-volume products and over-
cost high-volume sample products (ii) it may result in improved cost control. The limitation of ABC system and two-fold (a) it is costly to
develop land maintain and (b) it is used to develop full costs and does not measure the incremental costs needed to produce an item.