Activity-Based Costing: Better Costing For Better Decisions

Activity-Based Costing
Better Costing for Better Decisions
1
Indirect Costs
 Not easily and conveniently traceable to cost

objects
 Cost element is shared among cost objects
 Physically impossible to trace
 Not cost effective to trace
2
Traditional Allocation Method
 Indirect costs allocated to cost object based

on the cost object’s consumption of some
measure of activity, usually labor hours
Rs 10,000,000 total indirect cost

= Rs 25 per hour rate
400,000 total labor hours
A product consuming 6 labor hours would be charged Rs

150 of indirect costs
3
Criticisms of Traditional Overhead
Allocation
 Assumes all overhead is volume-related
 Factory-wide or departmental rates
 All related to single activity measure
 Departmental focus, not process focus

 Focus on costs incurred, not cause of costs
4
 Purpose
 Allocation of indirect costs based on causal
activities
 Attempts to identify “direct” link between cost and cost
object
 Results in better allocation
5
 Traditional allocation method
Costs Products
 Activity-based allocation method
Costs Activities Products
First stage Second stage
6
Overview of ABC
 Identifies activities required to produce the

product or service
 Determines the cost of the activities
 Allocates costs to the cost object based on
the object’s consumption of activities
7
Operation of an ABC System
 Assign costs to activity pools
 First stage allocation
 Identify the costs incurred to perform
various activities
 Determine the measure of activity

best related to each cost pool
 Cost drivers
8
Operation of an ABC System
 Determine rate per unit of activity

 Assign costs to products/services based on
consumption of activities
 Second stage allocation
 Indirect costs are converted to direct costs
9
Implementing ABC
 Step 1 – Plan the system

 What are the goals?
 Inventory valuation
 Process improvement
 Foster active involvement

 Assemble cross-functional team
 Functional specialists
10
Implementing ABC
 Step 2 – Define, analyze activities and
resources
 Decompose organization into elemental activities
 Who does what, and why?
 Interview employees
 Determine resources
 Determine inputs and outputs
11
Implementing ABC
 Gather statistics on activities
 Inputs and outputs
 Transaction, duration, intensity
 For possible use as second-stage cost drivers
12
Implementing ABC
 Step 3 – Establish activity cost pools
and determine first stage allocation
 First stage allocations assign costs to cost
pools
 Requires costs to be re-categorized according
to why they are incurred, not by type
 Drivers may be employee time, square footage,
etc.
13
Implementing ABC
 Step 4 – Determine second stage drivers and

assign costs to cost objects
 Outputs of activity analysis may be second stage
drivers
 Distance moved, times handled, machine hours, units,
etc.
 Amount assigned to the cost object is the amount

of activity consumed times the rate per unit of the
activity
14
When is ABC Most Useful?
 High amounts of overhead cost
 Multiple products
 Complex products
 Complex production system
 Significant variation in volume between high
and low volume products
15
When is ABC Most Useful?
 Different products place different demands on

resources
 Problems with current cost allocations due to
changes in products or processes
 Better cost information is needed
16
Activity-Based Management
 Natural extension of ABC
 Why are activities performed?
 Are they necessary?
 Are they consistent with organizational goals?
 How are they performed?
 Are they performed efficiently?
 Can they be redesigned or eliminated?
17
ABM for Process Improvement
 Focus on problems, opportunities

 Prioritize opportunities for improvement
 Most critical
 Greatest potential for cost savings
18
 Determine and explain causes for problems

and opportunities
 Cannot improve the system without first
understanding it
 Select specific improvement projects
19
 Use ABC/ABM data to test potential impact of

changes
 Make changes
 Iterate
 Process of continual improvement
20
Implications of ABC/ABM
 Shifts focus from managing costs to
managing activities
 Aids in recognizing, measuring and
controlling complexity
 Promotes understanding of why costs
are incurred
 Provides better cost allocation
information
21
Implications of ABC/ABM
 Useful for planning future operations

 Fosters continuous improvement
 Likely to meet with substantial
resistance
 Analysis of why and how activities are
performed
22

Activity-Based Costing: Better Costing For Better Decisions

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Activity-Based Costing

Better Costing for Better Decisions

 Not easily and conveniently traceable to cost

 Indirect costs allocated to cost object based

Rs 10,000,000 total indirect cost

A product consuming 6 labor hours would be charged Rs

 Departmental focus, not process focus

 Results in better allocation

 Traditional allocation method

 Activity-based allocation method

Costs Activities Products

First stage Second stage

 Identifies activities required to produce the

 Determine the measure of activity

 Determine rate per unit of activity

 Indirect costs are converted to direct costs

 Step 1 – Plan the system

 Foster active involvement

 Step 4 – Determine second stage drivers and

 Amount assigned to the cost object is the amount

 Different products place different demands on

 Focus on problems, opportunities

 Determine and explain causes for problems

 Select specific improvement projects

 Use ABC/ABM data to test potential impact of

 Useful for planning future operations

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