Activity Based Costing Activity Based Management Costing and
Activity Based Costing Activity Based Management: Costing and ABC-Classification Activity of Based organizational activities for an ABC system-Traditional Cost systems and ABC systems–Limitations of ABC-Activity Based Management. Customer Profitability Analysis/Customer Analysis (CPA)-CPA and ABM-The implementation of CPA.
Activity based costing(ABC) is a costing methodology that indentifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. Activity based costing developed to provide moreaccurate ways of assigning the costs of indirect and support resources to activities, business process, products, services and customers.
ABC attempts to first identify the activities being performed by the organization’s support resources. Then it traces the resources expenses of the support resources to the activities, ending up with the total cost of performing each of the organization’s support activities. In the nest stage, ABC system trace activity cost to products by identifying a cost driver for each activity, calculating an activity cost driver rate, and using this rate to drive activity costs to products.
Cost drive: A cost driver is a factor that causes cost to incur, such as machine hours, direct labor hours and direct material hours.
Classification of organizational activities for an ABC system Unit –Level Activities: Cost drivers for unit-level activities include labor hours, machine hours and materials quantity processed. Batch –Level Activities: Amount of material handling Number of setups Number of inspections Amount of production scheduling
Customersustaining Product sustaining Batch Unit ABC Hierarchy of Activities
Traditional Costing Vs. Activity-Based Costing Two common costing business are • Traditional costing and • Activity-based costing. systems used in
• Traditional costing assigns manufacturing overhead based on the volume of a cost driver, such as the amount of direct labor hours needed to produce an item. • Activity-based costing allocates the costs of manufacturing a product according to the activities needed to produce the item.
• Under traditional costing, accountants assign manufacturing costs only to products. Traditional accounting fails to allocate nonmanufacturing costs that also are associated with the production of an item, such as administrative expenses. • Greater costing accuracy is the primary benefit of activitybased costing. Companies assign cost only to the products that require the activity for production. This method eliminates allocating irrelevant costs to a product.
• Another disadvantage of solely using the traditional costing system is that it can lead to bad management decisions because it excludes certain nonmanufacturing costs. • Activity-based costing includes an easy interpretation of cost for internal management, the ability to enable benchmarking and a greater understanding of overhead costs.
• Companies commonly use traditional accounting in external financial reports because it provides a value for the cost of goods sold. An advantage of using traditional-based costing is that it aligns with Generally Accepted Accounting Principles, or GAAP. • ABC does not conform to accounting standards and should not be used for external reporting.
• Easy implementation of traditional accounting for companies that provide one product also is a plus. • Implementing an activity-based costing system within a company requires substantial resources. This can prove a disadvantage for companies with limited funds. Another disadvantage of using activity-based costing is that it is easily misinterpreted by some users.
Traditional costing is an outdated costing system in many companies because those manufacturing companies now use machines and computers for much of their production. Computers and machines make the system outdated because it often uses direct labor hours to calculate cost. Cost is not appropriately assigned because direct labor hour is not the best cost driver to use. Traditional costing negates other cost drivers that may contribute to the cost of an item.
Activity-based costing determines every activity associated with producing an item and allocates a cost to the activity. The cost assigned to the activity is then assigned to products that require the activity for production.
Limitations of ABC-Activity Based Management Expensive Implementation Setting up an ABC system can be expensive and time-consuming. As business activities are analyzed, they must be broken down into each activity’s individual components. The entire process can use up valuable resources as data are collected, measured and entered into the new system. Businesses may also need the assistance of a consultant who specializes in the setup of an ABC system and can provide training on its use. Using software can additional expense to the implementation but it can be used to automate many of the manual aspects involved in using ABC.
Misinterpretation of Data Reports produced by an ABC system contain information, such as product margins, that vary from the information reported for a traditional cost method. It’s also possible that some activitybased costs may be irrelevant in certain decision-making scenarios; for example, ABC does not conform to accounting standards and should not be used for external reporting. Since traditional cost figures tend to be the norm, interpreting ABC data along with regular accounting information can be confusing and lead to bad decision-making. The use of software can streamline the process of maintaining an ABC system and simplify its integration with regular cost accounting information.
Activity Cost pool Activity Designing Expense 2, 37, 000 Quality Control 5, 72, 000 Machine Maintenance 3, 000 Logistic Expense 1, 14, 000 78, 000 Preparation Cost Drive Product Unit Manufactured Executive Edition 1760 Home Edition 2717 Student Edition 4, 376 Quantity Executive Home Student Total cost drive quantity Designing hours 3755 3390 2435 9580 Inspection 532 490 298 1320 Machine hrs 915 835 700 2450 Trips 4765 4360 1, 015 10, 140 Setup 1, 371 1, 131 898 3400
Activity Designing Expense Quality Control Machine Maintenance Logistic Expense Preparation Cost Activity Cost Total cost pool drive quantity Cost per drive 237000 9580 24. 74 572000 300000 1320 2450 433. 33 122. 45 114000 78, 000 10, 140 3400 11. 24 22. 94
Activity Cost Drive Executive QTY Home Per Activity Drive Cost cost QTY Per Activity QTY Drive Cost cost 92898. 7 3390 24. 74 83868. 6 2435 Per Activity Drive Cost cost 24. 74 60241. 9 Designing Expense Designing hours 3755 Quality Control Inspection 532 433. 33 230531. 56 490 433. 3 212331. 7 298 433. 3 129132. 34 915 122. 45 112041. 75 835 122. 5 102245. 75 700 122. 5 Machine hrs Maintenanc e 24. 74 Student 53558. 6 4360 11. 24 Logistic Expense Trips 4765 11. 24 Preparatio n Cost Setup 1, 371 22. 94 31450. 74 1, 131 22. 94 25945. 14 898 22. 94 20600. 12 520481. 35 49006. 41, 015 11. 24 85715 473397. 59 11408. 6 307097. 96
per unit cost of Executive Edition : 520481 / 1760 = 295. 73 per unit cost of Home Edition : 473398 / 2717 = 174. 24 per unit cost of Student Edition : 307098 / 4, 376 = 70. 18
Two models of a product manufactured and sold by one company, Model A and Model B. Following table shows some information relating to these two products. Products Compared Units produced & sold Product A Product B 9, 000 Total 5, 000 14, 000 Selling price / unit Tk 3. 00 Tk 2. 00 Direct labor cost / unit Tk 0. 50 Direct materials cost / unit Tk 0. 75 Tk 0. 50 The company's cost accountants also find cost totals for support activities for the entire period production of products A and B. In traditional cost accounting, these are called "overhead" or "indirect costs, " which can be summarized as below: Indirect Components Prod. A & B Indirect Cost Materials purchasing Tk 180, 000 Machine setups Tk 375, 000 Product packaging Tk 280, 000 Machine testing & calibration Tk 300, 000 Machine maintenance & cleaning Tk 287, 000 Total Indirect Cost Tk 1, 422, 000
The following table shows the number of CD (cost drive) units (activity units) used for product A and B. Activity Pool Cost Driver (CD) Activity Units Product A Product B Purchase orders No of purchase orders 75 25 Machine set ups No of setups 150 100 Product packaging No of product packages packed 9, 000 5, 000 Machine testing & calibration No of tests 1, 000 2, 000 No of batch runs 200 50 Maintenance & cleaning Total Activity Required: Calculate Gross profit for each product by using traditional costing and activity based costing for indirect or overhead costs.
Activity Cost Total cost Cost per drive pool drive quantity Materials purchasing Tk 180, 000 100 Machine setups Tk 375, 000 250 Product packaging Tk 280, 000 14, 000 Machine testing & calibration Tk 300, 000 3, 000 Machine maintenance & cleaning Tk 287, 000 250 18, 00 1, 500 0. 20 100 1148
Activity Cost Drive Product A QTY Materials purchasing Machine setups Product packaging Machine testing & calibration Machine maintenance & cleaning Per Drive Activity cost Cost Product B QTY Per Drive Activity Cost cost No of purchase orders 75 18, 00 1, 35, 000 25 18, 00 45, 000 No of setups 150 1, 500 2, 25, 000 1, 500 1, 50, 000 No of product packages packed 9, 000 0. 20 1, 80, 000 5, 000 0. 20 1, 000 No of tests 1, 000 2, 000 100 2, 000 No of batch runs 200 1148 57, 400 1148 2, 29, 600 8, 69, 600 50 5, 52, 400
per unit indirect cost of Product A: 8, 69, 600 / 9, 000 = 0. 9662 per unit indirect cost of Product B : 5, 52, 400 / 21, 000 = 0. 2630 Products Cost Product A Product B Direct labor cost / unit Tk. 0. 50 Direct materials cost / unit Tk. 0. 75 Tk. 0. 50 Indirect Cost TK. 0. 97 Tk. 0. 26 2. 22 1. 26
Activity Based Management Activity-based management and activity-based costing (ABM/ABC) have brought about radical change in cost management systems. The principles and philosophies of activity-based thinking apply equally to service companies, government agencies and process industries. ABM enables management to make informed decisions about lines of business, product mix, process and product design, what services should be offered, capital investments, and pricing.
Organisations are moving from managing vertically to managing horizontally. It is a move from a function orientation to a process orientation. Total quality management (TQM), just-in-time (JIT), benchmarking and business process reengineering (BPR) are all examples of horizontal management improvement initiatives. These initiatives are designed to improve an organisation's work processes and activities to effectively and efficiently meet or exceed changing customer requirements.
ABM draws on ABC to provide management reporting and decision making. ABM supports business excellence by providing information to facilitate long-term strategic decisions about such things as product mix and sourcing.
Management information systems to track and provide information about the horizontal aspects of a business have lagged significantly behind the needs of its managers. Activity-based costing/activity-based management fills this information need by providing cost and operating information that mirrors the horizontal view. The focus of ABC is on accurate information about the true cost of products, services, processes, activities, distribution channels, customer segments, contracts, and projects.
Activity-based management makes this cost and operating information useful by providing value analysis, cost drivers, and performance measures to initiate, drive or support improvement efforts and to improve decision making.
ABM also supports the quest for continuous improvement by allowing management to gain new insights into activity performance by focusing attention on the sources of demand for activities and by permitting management to create behavioural incentives to improve one or more aspects of the business. ABM will not reduce costs, it will only help understand costs better to know what to correct.
Limitations Companies considering or already implementing ABM should realise that although certain product or market factors might make it potentially beneficial, those same factors might not lead to a successful implementation. ABM gives us a much better chance of establishing a useful costing for outputs. But there is a price to pay. It can be difficult to find out what costs apply in a particular activity, and those involved may be suspicious of others charged with finding out. Some areas of activity overlap and are difficult to separate. And, of course, ABM is a costly exercise in its own right.
Customer profitability management (CPM) is a strategy-linked approach to identifying the relative profitability of different customers or customer segments in order to devise strategies that add value to most-profitable customers, make lessprofitable customers more profitable, stop or reduce the erosion of profit by unprofitable customers, or otherwise focus on long-term customer profitability. Managing profitability requires not only a customer-centric focus but also a thorough understanding and effective management of customer profitability.
THE PRODUCT PROFITABILITY WHALE CURVE An activity-based cost analysis, in which the costs of indirect and support resources are applied on the basis of activities performed and the demand for the activities by individual products, can reveal a quite different story about the profitability of many of the company's products.
300% Cumulative profit 50% 20% Most profitable products Least profitable products
Companies encounter a whale curve of cumulative product and customer profitability in activity-based cost systems built for business units that 1. Large expenses in indirect and support resources 2. Diversity in products, customers, and processes
Managers, once they understand their product costs after an ABC analysis, have a great array of actions available to them to increase the profitability of their product lines. The actions, some of which are identified below, are often called activity-based management, referring to managers' decision making using information about activities. §Reprice products §Substitute products §Redesign products § Improve processes and operations strategy § Technology investment § Eliminate products
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