ACTIVITY BASED COSTING Module 11 ACTIVITY BASED COSTING Dr. Varadraj Bapat

Activity Based Costing (ABC) Concept of ABC Traditional Costing V/s ABC Treatment of cost under ABC Steps of ABC Benefits Limitations Activity Based Management: ABM Relation between ABC & ABM Dr. Varadraj Bapat

Reasons to choose the right way of costing In business, arriving at the correct cost is very important, because it: • identifies money-makers and money losers; • finds an economic break-even point; Dr. Varadraj Bapat

• facilitates opportunities for cost control • facilitates opportunities for cost control. • permits comparison of different options; and • enables strategic decision making. Dr. Varadraj Bapat

The Concept of ABC Activity-Based Costing Departmental Overhead Rates Level of Complexity Plant-wide Overhead Rate Overhead Absorption Dr. Varadraj Bapat

The Concept of ABC Overhead Absorption Departmental Overhead Rates Department D1 OH Rate = Overheads Apportioned / Machine Hours Plant-wide Overhead Rate Plant OH Rate = Overhead Cost / Machine Hours Dr. Varadraj Bapat

Introduction ABC is a costing system, which focuses on activities performed to produce products. ABC relates cost (resources consumed) to work accomplished (outputs produced). Dr. Varadraj Bapat

ABC is a management tool that provides better allocation of resources. The ABC or unit cost goal is a benchmark that represents an expectation of the cost incurred for the production of an output. Dr. Varadraj Bapat

ABC aligns costs to outputs thereby increasing cost visibility, and is useful in forecasting financial baselines. Dr. Varadraj Bapat

Traditional Costing V/s ABC Resources Everything in Organization Resources Traced by Resource Drivers Allocate Consume What is actually being done Activities Cost Centre Consume Traced by Activity Drivers -Products/Services - Customers - Etc - Products - Services Objects Objects

Cost objects consume activities. Activities consume resources. ABC’s Basic Premise Cost objects consume activities. Activities consume resources. This consumption of resources is what drives costs. Understanding this relationship is critical to successful budget management. Dr. Varadraj Bapat

Treatment of Costs under ABC In ABC, products are assigned the overhead costs that are supposed to be related to the allocation base. Non-manufacturing costs Manufacturing costs Plant wide Overhead Rate Departmental Overhead Rates Costs of idle capacity Dr. Varadraj Bapat

ABC’s Basic Steps 1 . Analyze activities. 2 . Gather cost data. 3 . Trace costs to activities. 4 . Establish output measures. 5 . Analyze costs. Dr. Varadraj Bapat

Makes it possible to determine production cost traced to outputs. ABC’s Basic Benefits Makes it possible to determine production cost traced to outputs. Targets areas needing management attention. Encourages the consideration of alternative methods of production. Highlights operational efficiency. Dr. Varadraj Bapat

Identifies financial benchmarks for activity performance. Generates more information to measure and reward performance, and prioritizes activities for cost reductions. Provides a common managerial framework among support activities. Dr. Varadraj Bapat

Trade-off between expense and accuracy. Need for more precise data Limitations of ABC Trade-off between expense and accuracy. Need for more precise data Need of full support of top level management, and support of ABC based performance review. Dr. Varadraj Bapat

Cases of overstated costs and under-stated margins and mistakes in pricing and other critical decisions. Dr. Varadraj Bapat

Activity Based Management 18 Activity Based Management Activity based management involves any use of ABC information to support the organization’s strategy, improve operations, or manage activities and their resulting costs. Dr. Varadraj Bapat

Activity Based Costing 19 Activity Based Costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs. Dr. Varadraj Bapat

Relation ABC and ABM Process View Resource costs Cost Objects ABM Root 20 Relation ABC and ABM Resource costs Cost Assignment View ABM Root Causes Process View Activity Analysis Performance Measures Activity Evaluation Activities Activity Triggers Cost Objects Dr. Varadraj Bapat

Eliminating non-value added costs using ABM 21 Eliminating non-value added costs using ABM Identifying Activities Identifying non-value added activities Understanding activity linkage, root causes and triggers Establishing performance measures Reporting non value added costs Dr. Varadraj Bapat

ABM seeks to satisfy following customers needs 22 ABM seeks to satisfy following customers needs Lower costs Higher quality Faster response time Greater innovation Dr. Varadraj Bapat

Customer Profitability Analysis 23 Customer Profitability Analysis Customer profitability analysis uses activity-based costing to determine the activities, costs and, profit associated with serving particular customers. Dr. Varadraj Bapat

Customer Profitability Analysis 24 Customer Profitability Analysis A costly customer is one: Orders small quantities Demands faster service Requires special packaging Often changes orders Orders frequently Dr. Varadraj Bapat