Activity Based Costing By Jan Van Deusen Larry Inguagiato

Outline Overhead Cost Discussion History behind Activity Based Costing Activity Based Costing What is it? Who does it? How is it done? What do you do with it? Why activities – management uses Target Costing Conclusion Questions

Traditional Accounting This is how manufacturing has traditionally tracked costs.

Shifting Trends in Accounting Traditionally overhead costs have been allocated based on labor costs of a product. As technology increases labor costs constitute a lesser portion of product costs. Also modern companies manage highly diversified product lines, which makes random assignment of overhead a… PROBLEM

Overhead Example Product A consists of 20 components costing $180 and has an assembly time of 2 hrs at a labor cost of $20. Overhead is applied based on a direct labor factor of 120% which results in a cost of $44. The total cost of Product A is $244. Product B consists of 5 components costing $180 and has an assembly time of 2 hrs at a labor cost of $20. Overhead is applied based on a direct labor factor of 120% which results in a cost of $44. The total cost of Product B is $244. Does this sound right????

Overhead example The key to the example is the difference in the number of components Logically assembling 20 components must have more cost associated with it than assembling 5 components The indirect overhead costs of ordering, receiving, stocking and issuing the difference in components are not accounted for This is the problem with traditional accounting

History behind ABC ABC became practiced in the early 1980’s but it has really become a force in industry in the mid to late 1990’s Most current approaches to ABC are based on concepts developed by the Computer Aided Manufacturing-International (CAM-I) Project Since then ABC plans have been further developed and diversified down to mid and small size companies

ABC – What is it? ABC is the Activity Based Cost accounting method. ABC focuses on identifying all activities associated with making a product or doing a process.

ABC – What is it? (cont) Activity = Cost Identifying activities will yield a total cost system.

ABC has 3 strategic objectives: Report accurate costs Identify costs of activities Identify future need for resources ABC – What is it? (cont)

Who is involved in it? Engineers Accountants Management Factory workers Shipping personnel Sales ……………….EVERYONE!

ABC Terms Activity = work performed within an organization. Resource = financial input consumed by activities. Resource Driver = any measure of the quantity of resources consumed by activities. Activity Driver = any measure of the frequency and intensity imposed by a cost object. Cost object = any customer, service, process that a separate cost measurement is desired.

ABC Costs Resource Driver Business Process

How is ABC done? 1. Identify activities. 2. Determine how resources are linked to activities. (traced, assigned, allocated costs) 3. Calculate activity costs. 4. Identify cost objects. 5. Determine how activities are related to cost objects. 6. Calculate cost of object costs.

ABC Cost Example

Degrees of Implementation Tier 1 – Direct Costs Tier 2 – Incremental Costs Tier 3 – Full Costs

Tier 1 – Direct Costs Direct costs obviously associated with product including managerial costs. Ex: personnel payroll, supplies, rental equipment. Overhead and support costs not included. Oriented for small projects or improving a process vs focus on price of production or where infrastructure is too large to determine overhead and support costs accurately.

Tier 2 – Incremental Costs Tier 1 costs + support costs of organization. Incremental costs typically include over 95% of the organizational costs. More difficult than Tier 1 due to subjective distribution of expenses across multiple elements.

Tier 3 – Full Costs Tier 3 includes all organizational, managerial, direct, support and overhead costs. This is the most comprehensive, difficult. Least used method.

What do you do with it? Use the collected data to make smarter business decisions.

Why activities – management uses Activities are actions Improve product cost accuracy Activities drive cost Facilitates evaluation of alternatives Encourages continuous improvement Activities are easily understood by user level Improve decision support

Target costing Key Japanese design technique In Japan, cost is responsibility of design engineer – same as US in the 1920’s The Japanese treat cost as a symptom, not a cause or solution Begins with market-based pricing independent of cost – what the customer can pay

Target costing Japan: Target cost = Market-priced sales – Target profit Other countries: Actual cost + Planned profit = Price Conclusion: Costs are best managed during concept and design phase

Conclusion ABC is an excellent tool for identifying areas of concern in your company as well as being useful to integrate into management It is however just a tool and must be set-up and used properly in order to be beneficial

Questions?

Bibliography Electronic College of Process Innovation, Department of Defense at Brimson, James. “Activity Accounting”. John Wiley & Sons, Inc., Cokins, Gary. “Activity Based Cost Management”. McGraw-Hill, Cooper, Robin and Slagmulder, Regine. “Activity Based Budgeting, Part 1.” Strategic Finance. Montvale, September 2000.

Bibliography Deo, Baldinger S. and Strong, Doug. “Cost: The Ultimate Measure of Productivity.” Industrial Management. Norcross, May/June Grieco, Peter & Pilachowski, Mel. “Activity Based Costing: The Key to World Class Performance”. PT Publications, Inc, Marcino, George R. “Obliterate Traditional Budgeting.” Financial Executive. November/December Yennie, Henry. “ABC: The New Cost – Cutting Tool.” Behavioral Health Management. Cleveland, September/October 1999.