ACTIVITY-BASED COSTING

Presented by:
Komathi Palasubramaniam
Navaneetham Your Rajah
Veshaleni Sritharan
Jayamalini Subramaniam
Gpoovaneswary Ganesan
Presented for:
[Link] Hanafi
Date:
19th October 2014

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OVERVIEW OF ACTIVITY BASED

COSTING (ABC)

To support compliance with financial reporting

requirements, a companys traditional costaccounting system is often articulated with its
general ledger system.
In essence, this linkage is grounded in cost
allocation.
Typically, costs are allocated for either valuation
purposes (i.e., financial statements for external
uses) or decision-making purposes (i.e., internal
uses) or both.
However, in certain instances costs also are
allocated for cost-reimbursement purposes (e.g.,
hospitals and defense contractors).

The traditional approach to costallocation consists of three basic steps:

Cont

Costs derived from this traditional allocation approach

suffer from several defects that can result in distorted
costs for decision-making purposes.
For example, the traditional approach allocates the
cost of idle capacity to products. Accordingly, such
products are charged for resources that they did not
use.
Seeking to remedy such distortions, many companies
have adopted a different cost-allocation approach
called activity-based costing (ABC).

What is
ABC???

EXPLAINATION OF ABC
ABC systems first accumulate overhead costs for
each organizational activity, and then assign the
costs of the activities to the products, services, or
customers (cost objects) causing that activity.
As one might expect, the most critical aspect of ABC
is activity analysis.
Activity analysis is the processes of identifying
appropriate output measures of activities and
resources (cost drivers) and their effects on the
costs of making a product or providing a service.
An activity is any event or transaction that is a cost
driver.

Cont
Two common types of activity measures:Transaction Driver

Simple count
of the number
of times an
activity
occurs

Duration Driver

A measure of
the amount of
time needed
for an activity

Cont
Examples of activities that are cost drivers
include: Machine setups
Purchase orders
Machine time
Power consumed
Flight hours logged
Maintenance request
Activity analysis provides the foundation for
remedying the distortions inherent in traditional
cost-accounting systems.

HOW COST ARE TREATED UNDER

ABC?
In traditional cost accounting system, only
manufacturing costs are assigned to products.
Selling, general, and administrative expenses are
treated as period costs 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.

Cont
For example commissions paid to salespersons,
shipping costs, and warranty repair costs can be easily
traced to individual products.
The term overhead is usually used to refer nonmanufacturing costs as well as indirect manufacturing
costs under an ABC system.
In activity based costing, products are assigned all of
the costs, manufacturing as well as non-manufacturing
that they can reasonably be supposed to have caused.
The entire cost of the product is determined rather
than just its manufacturing cost.

Cont
Manufacturing Cost

Non-manufacturing
Cost

Traditional
Product Costing

ABC Product
Costing

Cont
Traditional cost systems usually rely on volume
measures such as direct labor hours and/or
machine hours to allocate all overhead costs to
products.
ABC defines five levels of activity that largely do
not relate to the volume of units produced.
Manufacturing companies typically combine their
activities into five classifications.

FIVE LEVEL OF ACTIVITY OF

ABC

LEVEL OF ACTIVITIES
To identify resource costs for various activities, a firm
classifies all activities according to the way in which
the activities consume resources.
i. Unit Level Activity
A unit-level activity is performed on each individual
unit of product or service of the firm. (Examples :direct materials, direct labor-hours)
A unit-level activity is volume-based.
The required activity varies in proportion with the
quantity of the cost object.

Cont
ii. Batch-level Activity
A batch-level activity is performed for each batch
or group of units of products or services.
(Examples setting up machines, placing
purchase orders, scheduling production)
A firm incurs a batch-level activity for each batch
or group of units of products or services
scheduled to be processed together, rather than
for each individual unit of the cost object.

Cont
iii. Product Level Activity
A product-level activity supports the production of
a specific product or service. (Examples of productsustaining activities include designing products,
administering parts required for products)

iv. Customer Level Activity

Relate to specific customers and include activities
such as sales calls, catalog mailing, and general
technical support that are not tied to any specific
product.

Cont
v. Organization Sustaining Level Activity

A facility-level activity supports operations in

general. (Examples of facility sustaining activities
include providing security and safety, performing
maintenance of general purpose machines)
These activities are not caused by products or
customer service needs and cannot be traced to
individual units, batches, or products.
Some firms refer to these activities as business
or infrastructure sustaining activities.

DESIGNING ABC SYSTEM

Three essential characteristics of successful ABC
implementation
Top managers support
Ensure ABC data linked on people evaluation
and rewards
Cross functional team formed to design and
implement ABC system.

ABC Model

Cost Objects
(Products & Customer)

Activities

Consumption of
Resources

Cost

Step 1: Define Activities, Activity Cost

Pool, and Activity Measures
The first step in designing an ABC system is to
conduct an activity analysis to identify the
resource costs and activities of the firm.
Examples of these accounts include supplies,
purchasing, materials handling, warehousing and
etc.
Special effort will be needed
to determine
appropriate resource costs for activity-based
costing because generally several different
resource costs may be recorded in a single
account or the costs for an activity may be
recorded in several accounts.

Cont
Through activity analyses a firm identifies the
work it performs to carry out its operations.
Activity analyses include gathering data from
existing documents and records, as well as
collecting additional data using questionnaires,
observations, or interviews of key personnel.
In this step activities should be grouped together
at the appropriate level.

Example of Cost Pools and Activity

Measures

Activity Based Pools at Classic Brass Inc

Activity Cost Pools

Customer orders

Product Design

Order size

Customer Relations

Other

Number of customer orders

Number of product designs

Machine - Hours

Number of active custom

Not Applicable

Cost Pool
i.

ii.

Product Design
All costs of resources consumed by designing the
products.
The activity measure for this cost pool is the
number of products designed.
This is product level activity.
Order Size
Assigned to all costs of resources consumed as a
consequences of the number of units produces
(includes cost of miscellaneous).
This activity measure for this cost pool is machine
hours.

Cont
iii. Customer Relations
Assigned all costs associated with maintaining
relations with customers.

Including costs of sales calls and the costs of

entertaining customers.

The activity measure for this cost pool is

number of customers the company has on its
active customer list.

Cont
iv. Other Cost Pool

All overhead costs that are NOT associated with

customers orders, product design, the size of the
orders, or customers relations.

This type of costs mainly consists of organization

sustaining costs.

These costs WILL NOT to be assigned to

products because they represent resources that
are not consumed by products.

Step 2: Assign Overhead Costs to

Activity Cost Pools
Activity-based costing uses resource consumption cost
drivers to assign resource costs to activities.
Because activities drive the cost of resources used in
operations, a firm should choose resource consumption
cost drivers based on cause and effect relationships.
Resource consumption cost drivers include the number of
labor hours for labor intensive activities.
Employees for payroll-related activities
Setups for batch-related activities
Moves for materials-handling activities
Machine-hours for machine repair and maintenance
Square feet for general maintenance and cleaning
activities

Cont
The cost of the resources can be assigned to
activities by direct tracing or estimation.
Direct tracing requires measuring the actual
usage of resources by activities.
When direct tracing is not available,
department managers and supervisors need
to estimate the amount or percentage of time
(or effort) employees spend on each identified
activity.

Example Overhead Cost

Step 3: Calculate Activity Rates

The activity rates that will be used for
assigning overhead costs to products and
customers.
Activity Rate : Total Cost
Total Activity
Example 1 :
Total cost for customers orders $ 320000
Total Customer orders 1000

Cont
= $320,000
1000 orders
= $320 per
Example 2:
Total cost product design $252,000
400 designs
= $252,000
400
= $ 630 per design

Computation of Activity Rates

Step 4: Assigning Overhead Costs

to Cost Objects
This step of ABC called second stage allocation.
In this stage activity rates are used to apply overhead
costs to products and customers
This step is to assign costs of activities or activity cost
pools to cost objects based on the appropriate activity
consumption cost drivers.
Outputs are the cost objects for which firms or
organizations perform activities.
Typical outputs for a cost system are products and
services however, outputs also can include customers,
projects, or business units.
Firms use activity consumption cost drivers to assign
activity costs to cost objects.

Example Overhead Cost to Cost

Objects

Example of Overhead Cost to

Customers

Step 5: Prepare Management

Reports
The reports prepared with ABC data are
product and customer profitability reports.
This report help companies channel their
resources to their most profitable growth
opportunities

COMPARISON OF TRADITIONAL
AND ABC PRODUCT COST
In traditional cost accounting it is assumed that
cost objects consume resources whereas in ABC
it is assumed that cost objects consume activities.
Traditional cost accounting mostly utilizes volume
related allocation bases while ABC uses drivers at
various levels.
Traditional cost accounting is structure-oriented
whereas ABC is process-oriented.

Cont
Basically, the traditional costing is used commonly by
manufacturing companies to assign manufacturing
overheads to the units they produce.
Using this, only the products are assigned an overhead
cost by the accountant. The downside of this method of
costing is that it neglects to consider the nonmanufacturing costs like administration expenses which
are associated with production.
Today, such method is considered outdated because a
lot of the manufacturing companies already use
computers and machines for their production.
Also business accounting software is already being used
widely. On the brighter side, the traditional costing is
easy to use especially for those companies that have
one product.

Cont
Activity-based costing (ABC) is a more logical
method of assigning manufacturing overhead
costs to products.
Unlike traditional costing that simply assigns
costs based on the machine work hours, the ABC
assigns costs first to the activities and processes
that cause the overhead.
Then, these costs are assigned only to the
products that require the activities. Simply saying,
the ABC is typically used as a supplemental
costing system for businesses.

Cont
The traditional costing method focuses on
structure rather than on processes while
the ABC is more on the activities than on
structure.
Traditional costing method is already
obsolete especially with the changing
technology trends such as the introduction
of the business accounting software.
The ABC provides more accurate costs of
products.

TRADITIOANAL COSTING SYSTEMS

ACTIVITY-BASED COSTING SYSTEMS

EXAMPLE
A simple example of these costing methods can be
demonstrated with the costs of living in an apartment
with roommates. Two roommates in an apartment will
typically split the costs of rent, utilities and groceries,
and they have a couple of options for doing so. They
could simply total the cost of all of the bills and divide
it exactly in two. This would be similar to traditional
costing.
The roommates also have the option of determining
who uses specific utilities and paying only for what
each one uses. They can then create an itemized bill
for each roommate. For example, if one roommate
doesnt use the internet and the other doesnt use
cable, they wont have to pay those parts of the bill.
This method is similar to activity-based costing.

Advantages of ABC
ABC provides a more accurate cost per unit. As a
result, pricing, sales strategy, performance
management and decision making should be
improved.
It provides much better insight into what drives
overhead costs.
ABC recognizes that overhead costs are not all
related to production and sales volume.
In many businesses, overhead costs are a
significant proportion of total costs, and
management needs to understand the drivers of
overhead costs in order to manage the business
properly. Overhead costs can be controlled by
managing cost drivers.

Cont
It can be applied to derive realistic costs in
a complex business environment.
ABC can be applied to all overhead costs,
not just production overheads.
ABC can be used just as easily in service
costing as in product costing.

Disadvantages of ABC
ABC will be of limited benefit if the overhead costs
are primarily volume related or if the overhead is a
small proportion of the overall cost.
It is impossible to allocate all overhead costs to
specific activities.
The choice of both activities and cost drivers might
be inappropriate.
ABC can be more complex to explain to the
stakeholders of the costing exercise.
The benefits obtained from ABC might not justify
the costs.
Other systems may need to be changed - for
example, how variances are calculated.

ACTIVITY BASED MANAGEMENT

In order to manage costs, a manager should focus
on the activities that give rise to such costs.
Accordingly, given the activity focus of ABC,
managers should implement ABC systems in order
to facilitate cost management.
Using ABC systems to improve financial
management is called activity-based management
(ABM).
The goal of ABM is to improve the value received
by customers and, in doing so, to improve profits.

Cont
The key to ABM success is distinguishing between
value-added costs and non-value-added costs.
A value-added cost is the cost of an activity that
cannot be eliminated without affecting a products
value to the customer.
In contrast, a non-value-added cost is the cost of
an activity that can be eliminated without
diminishing value.

Cont
Some value-added costs are always necessary, as
long as the activity that drives such costs is performed
efficiently.
However, non-value-added costs should always be
minimized because they are assumed to be
unnecessary.
Examples of non-valued added activities include
storing and handling inventories; transporting raw
materials or partly finished products, such as work-inprocess inventory items, from one part of the plant to
another; and redundancies in production-line
configurations or other activities.

END OF SLIDE

THANK YOU.