Activity-Based Costing and Activity-Based Management

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Background
y 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. y These methods often involve tradeoffs between simplicity and realism Simple Methods Unrealistic Complex Methods Realistic

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Broad Averaging
y Historically, firms produced a limited variety of goods

while their indirect costs were relatively small. y Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurred
y Peanut-butter Costing

y The end-result: overcosting & undercosting

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Over & Undercosting

y Overcosting

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

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Cross-subsidization
y The results of overcosting one product and

undercosting another. y The overcosted product absorbs too much cost, making it seem less profitable than it really is y The undercosted product is left with too little cost, making it seem more profitable than it really is

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Case facts
y Plastim corp manufactures lenses for rear tail lights of automobiles. Under its contract with Tata motors y Produces 2 types, a complex lens CL5 and a simple lensS3. y Compex lens has special features in contrast to the simple lens y Operates at capacity and has low marketing costs and mini. customer servicing cost. y Business environment very competitive with rspect to simple lens y New supplir,JainMotors who offers to supply S3 Lens at Rs.53 well below Plastim s price of Rs.63. y Fortunately ,Same comp pressures do not exist for the complex lens priced at Rs.137 per lens.
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Simple costing system using a single Indirect cost Pool

y Identify the products that are the chosen Cost objects y Identify the Direct cost of the products y Select the cost allocation bases to use for allocating

Indirect costs to the products y Identify the indirect costs associated with each cost allocation base y Compute the indirect costs allocated to the products. y Compute total cost of the products by adding all direct and indirect costs.
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y CL5 15,000 UNITS AND S3 60,000 UNITS y 30,000 DIRECT manufacturing hours used to

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

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An Example: Plastim

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Plastim & Simple Costing

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Implementing ABC at Plastim

y Identify the products that are chosen as cost objects y Identify the direct costs of the products y Select the activities and the cost allocation bases to use

for allocating indirect costs to the products y Identify the indirect costs associated with each cost allocation base y Compute the rate per unit of each cost allocation base y Compute the indirect costs allocated to the products y 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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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
y Each method is mathematically correct y Each method is acceptable y Each method yields a different cost figure, which will lead to different Gross Margin calculations y Only Overhead is involved. Total Costs for the entire firm remain the same they are just allocated to different cost objects within the firm y 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
y A number of critical decisions can be made using this

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

y 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

y Increase in product diversity y Increase in Indirect Costs y Advances in information technology y Competition in foreign markets

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Cost Hierarchies
y ABC uses a four-level cost structure to determine how

far down the production cycle costs should be pushed:

y Unit-level (output-level) y Batch-level y Product-sustaining-level y Facility-sustaining-level

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ABC vs. Simple Costing Schemes

y ABC is generally perceived to produce superior costing

figures due to the use of multiple drivers across multiple levels y 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
y A method of management that used ABC as an

integral part in critical decision-making situations, including:

y Pricing & product-mix decisions y Cost reduction & process improvement decisions y Design decisions y Planning & managing activities

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Signals that suggest that ABC implementation could help a firm:

y Significant overhead costs allocated using one or two

cost pools y Most or all overhead is considered unit-level y Products that consume different amounts of resources y Products that a firm should successfully make and sell consistently show small profits y Operations staff disagreeing with accounting over manufacturing and marketing costs
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ABC and Service / Merchandising Firms

y ABC implementation is widespread in a variety of

applications outside manufacturing, including:

y Health Care y Banking y Telecommunications y Retailing y Transportation

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