Activity Based Coting Examples

25437446.doc

ACCORDING TO AMERICAN ACCOUNTING ASSOCIATION • Cost is a forgoing, measured in monetary terms, incurred or potentially to be incurred to achieve a specific objective. • Each modification implies a certain attribute which is important in computing and measuring the cost which is to serve the management levels in achieving their basic objectives of planning and control. • It is a fundamental axiom that a cost must be understood in its relationship to the aims or purposes which it is to serve.

• To discover opportunities for cost improvement. • To prepare and actualize a business plan. • To improve strategic decision making.

1. Direct costing. 2. Traditional costing. 3. Activity based costing ABC.

ABC was first clearly defined in 1987 by Roberts Kaplan and W.Bruns. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect cost. For Example, Increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost. Page 1 of 14

25437446.doc

DEFINITION OF ACTIVITY-BASED COSTING “A method of measuring the cost and performance of activities and cost objects.”

DETIALS ABOUT ABC SYSTEM:Activity based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore fixed costs. Activity based costing is ordinarily used as a supplement to rather than as a replacement for the companies usual costing system. Most organization that use activity based costing have two costing system the official costing system that is used for preparing external financial reports and the activity based costing system that is used for internal decision making and for managing activities.

IN ACTIVITY-BASED COSTING SYSTEM: 1. Non-manufacturing as well as manufacturing costs may be assigned to product. 2. Some manufacturing costs may be excluded from product cost. 3. A number of over head cost pools are used, each of which is allocated to product and other costing objects using its own unique measure of activity. 4. The allocation bases often differ from those used in traditional costing systems, 5. The overhead rates, or activity rates, may be based on the level of activity at capacity rather than on the budgeted level of activity.

You cannot compete or even begin to compare until you know how to cost. ABC is a cost accounting methodology that can provide definitions of processed, identify what the cost drivers of those processes are, determine the unit costs of various Page 2 of 14

25437446.doc products and services, and create various reports on agency components that can be utilized to generate activity or performance based budgets. A major advantage of using ABC is that is avoids or minimizes distortions in product costing that result from arbitrary allocations of indirect costs. Unlike more traditional line item budgets which cannot be tied to specific outputs, ABC generates useful information on how money is being spent, if a department is being cost effective, and how to benchmark (or compare oneself against others) for quality improvements. Activity based costing also provides a clear metric for improvement. It encourages management to evaluate the efficiency and cost effectiveness of program activities. Some ABC systems rank activities by the degree to which they add value to the organization or its outputs. This helps managers identify what activities are really value added those that will best accomplish a mission, deliver a service, or meet customer demand thus improving decision making through better information, and helping to eliminate waste by encouraging employees to look at all costs. That is why an essential aspect of any ABC endeavor is to get a clear picture of the activities a business area performs, when employees understand the activities they perform, they can better understand the costs involved. Up to this point in managerial accounting we have discussed product costing systems primarily designed to provide unit product cost information for financial statement purposes. These systems use actual direct material cost, actual direct labor cost, and a volume based allocation rate to apply overhead to cost products. Overhead is applied based on a predetermined overhead rate calculated by dividing total estimated manufacturing over head by some volume allocation base such as direct labor hours or machine hours. Now we are going to study a new costing system, activity based costing. Note that ABC will not take the place of the financial statement costing system but will be used as a supplemental costing system for management purpose.

Page 3 of 14

25437446.doc

1. 2. 3. 4. 5.

Sales are increase but profits are declining. Overhead rates are very high and increasing overtime. Product lines are diverse. Direct labor is small percent of total cost. Competitors’ high-volume product seems to be priced unrealistically low.

The implementation process is broken down into following six basic steps: STEP 1: IDENTIFY AND DEFINE ACTIVITIES AND ACTIVITY COST POOLS: The first step in implementing an ABC system is to identify the activities that will form the foundation for the system. A common procedure is to interview people who work in overhead departments about their major activities. This results in very long list of activities. On one hand, the greater the list of activities tracked in the ABC system, the more accurate the costs are likely to be. On the other hand, it is costly to design, implement, maintain, and use a complex system involving large numbers of activities. The original list of activities is usually reduced to a handful by combining similar activities. For example, several actions may be involved in handling and moving raw materials – from receiving raw materials to sorting them into the appropriate bins in the storeroom. All these activities might be combined into single activity called “material handling”. A general way of combining activities is to organize them into five levels: 1. UNIT-LEVEL: Unit-level activities are performed each time a unit is produced. 2. BATCH-LEVEL: Batch-level activities are performed each time a batch is handled or processed, regardless of how many units in the batch.

Page 4 of 14

25437446.doc 3. PRODUCT-LEVEL: Product-level activities relate to specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold. 4. CUSTOMER-LEVEL: Customer-level activities relate to specific customers and include activities such as sales calls, catalog mailings, and general technical support that are not tied to any specific product. 5. ORGANIZATION-SUSTAINING: Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. In general it is best to combine only those activities that are highly correlated with each other within a level i.e., if they tend to move in tandem. After this activity cost pools are selected. An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. An activity measure is an allocation base in an activity based costing system. The term cost driver is also used to refer to an activity measure. The activity measure should drive the cost being allocated. Activity measures are often very rough measures of resource consumption. Probably the least accurate type of activity measure is known as transaction driver. Transaction drivers are simple counts of the number of times an activity occurs such as the number of bills sent out to customers. However a more accurate type of activity measure known as duration driver may be used. Duration drivers are measures of the amount of time required to perform an activity such as time spent in preparing such bills. STEP 2: DIRECTLY TRACE OVERHEAD COSTS TO ACTIVITY AND COST OBJECTS: The second step in implementing an ABC system is to directly trace as many overhead costs as possible to the ultimate cost objects. The ultimate cost objects are products, customers orders, and customers. Consider an example below: The company’s annual cost includes manufacturing overhead and selling, general, and administrative costs. In the ABC system , all Page 5 of 14

25437446.doc of these costs are considered to be “overhead” and will be assigned to cost objects where appropriate. One of these overhead costs-shipping-can be traced directly to customer orders. The company is directly billed for each customer order it ships, so it is a simple matter to trace these costs to the customer orders. Customers do not pay these actual shipping costs; instead they pay a standard shipping charge that can differ substantially from actual bill that company receives from the freight company. STEP 3: ASSIGN COSTS TO ACTIVITY COST POOLS: In this step costs should be traced directly to the activity to the activity cost pools. It is quiet common for an overhead department to be involved in several of the activities that are tracked in the ABC system. In such situations, the costs of the department are divided among the activity cost pools via an allocation process called first-stage allocation. First-stage allocation is the process by which overhead costs are assigned to activity cost pools. Step 4: CALCULATE ACTIVITY RATES: In this step the total activity for each cost pool that would be required to produce the organization’s present product mix and to serve its present customers is determined. The activity rates are computed by dividing the total cost for each activity by its total activity. Activity rate = Total cost of each activity Total activity STEP 5: ASSIGN COST TO COST OBJECTS: The fifth step in the implementation of activity-based costing is called second-stage allocation. In the second stage allocation, activity rates are used to apply costs to products and customers. This allocation can be done using the following formula Activity Rate * Amount of Activity STEP 6: PREPARE MANAGEMENT REPORTS:

Page 6 of 14

25437446.doc In this step a report is prepared showing activity-based costing margins from an activity view. The overhead costs computed in previous steps are combined with direct materials and direct labor cost data. For each of the products, these combined costs are deducted from sales to arrive at product margins.

1. NON MANUFACTURING COSTS: In traditional cost accounting, only manufacturing costs are assigned to products, Selling, general and administrative expenses are treated as period expenses and are not assigned to products .However, many of these non manufacturing costs are also part of the costs of producing, selling, distributing and servicing products. For example, commissions paid to salespersons, shipping costs, and warranty repair costs can be easily allocated to individual products. In activity-based costing , products are assigned all of the overhead costs – manufacturing as well as non manufacturing- that they can reasonably be supposed to have caused. 2. MANUFACTURING COSTS: In traditional cost accounting, all manufacturing costs are assigned to products – even manufacturing costs that are not caused by the products. For example, a portion of the factory security guard’s wages would be allocated to each product even though the guard’s wages are totally unaffected by which products are made or not made during a period. In activity-based costing, a cost is assigned to a product only if there is good reason to believe that the cost would be affected by decisions concerning the product. 3. COST OF IDLE CAPACITY: In traditional cost accounting , predetermined overhead rates are computed by dividing budgeted overhead costs by a measure of budgeted activity such as budgeted direct labourhours.

Page 7 of 14

25437446.doc

Predetermined Overhead rate = Total Estimated Manufacturing Overhead Direct-labour hours or Machine hours

This practice results in • Applying the costs of unused, or idle capacity to products • Unstable unit product costs If budgeted activity falls, the overhead rate increases because the fixed components of overhead are spread over a smaller base, resulting in increased unit product costs.

• • to

In contrast to traditional cost accounting, in activity-based costing, products are charged for the costs of capacity they use – not for the costs of capacity they don’t use. In other words, the costs of idle capacity are not charged to products. This results in more stable unit costs consistency with the objective of assigning only those costs products that are actually caused by the products Instead of assigning the costs of idle capacity to products, in activity-based costing these costs are considered to be period costs that flow through to the income statement as an expense of the current period. This treatment highlights the cost of idle capacity rather than adding it in inventory and cost of goods sold. 4. FLOW OF ACTIVITIES: ABC tracks the flow of activities by creating a cause and effect link between the activity (resource consumption) and the cost object. The flow is through five core areas: • • • • •

Resources Resource drivers (% of time, sq ft occupied, equipment hours, etc) Activities Activity drivers (number of reports, number of items, number of moves, etc) Cost objects (products services, customers, market areas)

Diagrammatically we can show this as follows:

Page 8 of 14

25437446.doc

Page 9 of 14

25437446.doc

You will notice that the direction of the arrows are different; the ABC model brings detailed information from the processes up to assess costs and manage capacity on many levels whereas the TCA model simply allocates costs, down onto the cost objects without considering any 'cause and effect' relations. 5. CONSUMPTION OF RESOURCES CONSUMPTION OF ACTIVITIES:

VERSUS

In traditional cost accounting, underlying assumption is that costs can be managed. The benefit of the ABC mindset is that it opens up for a much wider array of measures when it comes to improving productivity. By investigating systematically what is being done, i.e. the activities, one will not only be able to identify surplus capacity if it occurs, but also lack of capacity and misallocation of capacity. A result of this might be that costs are cut the traditional way, but it might as well lead to a reallocation of capacity to where it is most needed which will yield high productivity

Page 10 of 14

25437446.doc 6. STRUCTURE-ORIENTATION VERSUS PROCESSORIENTATION: Traditional costing systems are more concerned about the organizational charts than the actual process. Traditional cost accounting systems are therefore structurally oriented and the process view is completely missing. The result is capacity management is known and resource management is unknown because the process is unknown. Capacity is measured as an expense and found easily in the traditional cost accounting system. Resources are required in order to do a job and measured as a cost, but the resource measures can only be found by investigating the processes. ABC is process-oriented. It gathers information from the processes it can be used to identify both capacity and resource allocation most productively. ABC can therefore give managers the ability to match the resource needs with the available capacity as closely as possible, and hence improving productivity. From this we understand that the structure oriented approach of traditional costing systems gives no decision. COST ASSIGNMENT AND ALLOCATION: TCA historically uses direct labour or some other volume related allocation basis for attributing costs. But as overhead has grown and new technologies have come, it goes without saying that assigning costs based on only 5 - 15% of total costs is highly risky. In fact, the incurred errors are up to several hundred percent. ABC assigns costs according to the causal relationship between activities and cost objects, which is captured using drivers, of which there are two types, activity drivers that keep track of how cost object behaviour influences activity levels and resource drivers that keep track of how the subsequent activity level affects the resource consumption. The drivers are estimates of actual cost behaviour and can therefore also be used to identify, or they are themselves, the critical cost factors. As the drivers are related to the actual processes, they can occur on several levels, some of the common levels are:

Page 11 of 14

25437446.doc •

•

•

•

Unit - these are triggered for every unit that is being produced. Generally it is a volume related driver similar to the traditional allocation bases. Batch - these drivers are triggered for every batch produced, eg production planning. The number of batches could be the driver. Product - product level drivers are triggered for every product regardless of the number of units and batches produced. Product development hours per product would be a good driver here as the more time taken to develop a particular product should be reflected in the product development costs attributed to that product. Facility - these drivers are not related to the products at all. Costs that are traced by such drivers will therefore be allocated to products and not traced. The difference between allocation and tracing is that allocation is quite arbitrary whereas tracing is based on 'cause and effect' relations.

In activity based costing system ease of adjustment codes are used for cost. There are three colours used for cost classification. 1. Green Colour Cost 2. Yellow Colour Cost 3. Red Colour Cost 1. GREEN COLOUR COST: The cost which is automatically adjusted with the changes in activity, without management action is green colour cost. Examples are • Direct material cost • Shipping cost, etc. 2. YELLOW COLOUR COST: The cost which need to be adjusted with the changes in activity but management action would be required are termed as green colour cost. Examples are Page 12 of 14

25437446.doc • • • • • • •

Direct labour cost Indirect factory wages Factory utilities Administrative wages and salaries Office equipment depreciation Marketing wages and salaries Selling expenses, etc.

3. RED COLOUR COST: The cost which are adjusted by management action and it is very difficult to adjust with the changes in activities are red colour cost. Examples are • Factory equipment depreciation • Factory/Administration building lease

Following are some limitations of activity-based costing system. 1. Implementing an activity based costing system is a major project that requires substantial resources. And once implemented, an activity-based costing system is more costly to maintain than a traditional direct-labour based costing system. 2. Activity-based costing data can be easily misinterpreted must be used with care when used in making decisions. 3. Managers insists on fully allocating all costs to products, customers and other costing objects in an activity-based costing system – including the cost of idle capacity and organization sustaining costs. This results in overstated cost and understated margins and mistakes in pricing and other critical decisions. 4. An organization involved in activity-based costing should have two cost systems – one for internal use and another for external reports. This is costlier than maintaining just one system and may cause confusion about which system is to be believed and relied on.

Page 13 of 14

25437446.doc

• • • •

Activity-based costing estimates the cost of resources consumed by cost objects such as product and customers. The approach taken in activity-based costing assumes that cost objects generate activities that in turn consumes costly resources. Activities form the link between costs and cost objects. Activity-based costing is concerned with overhead – both manufacturing overhead and selling, general, and administrative overhead.

Page 14 of 14