ActivityBased Costing Management

1
Activity-Based Costing Management
The more original a discovery, the more obvious
it seems afterwards. (Arthur Koestler)

• Dr. Jatin Pancholi
• Website http//www.jatinpancholi.com

Dr. Jatin Pancholi has compiled and prepared this
note from various sources, as the basis for class
discussion rather than to illustrate either
effective or ineffective handling of a management
situation. The handling of a management
situation requires personal guidance by a
professional. To obtain copies, request
permission to reproduce and to send feedback,
please contact via website http//www.jatinpanchol
i.com. Those wishing to co-author next edition of
this handout are requested to contact via the
website.
2
Programme Contents

• Usage of ABC to avoid Product-Undercosting and
  Product-Overcosting
• Key issues of ABC such as cost drivers,
  transaction costing, etc.
• Estimation of non-value added cost
• ABC to ABM

• Cost Concept Classification
• CVP Relationships
• Cost Allocation
• Evolution of ABC
• Distinction between
• Traditional Costing ABC
• Cost Hierarchy

3
Cost Concepts Classification

• Different cost concepts and terms are often used
  in accounting reports.
• Managers who understand these concepts and terms
  are able to...
• best use the information provided, and
• avoid misuse of that information.

4
Cost Meaning

• Cost is a resource sacrificed or forgone to
  achieve a specific objective.
• It is usually measured as the monetary amount
  that must be paid to acquire goods and services.

5
Cost Accumulation - Assignment

• There are two basic stages of accounting for
  costs
• Cost accumulation
• Cost assignment to various cost objects

6
Cost Accumulation - Assignment (2)

• Cost accumulation is the collection of cost data
  in some organized way by means of an accounting
  system.
• Cost assignment is a general term that
  encompasses...
• tracing accumulated costs to a cost object,
• allocating accumulated costs to a cost object.

7
Classification of Cost Concepts
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CVP

• Cost-volume-profit (CVP) analysis examines the
  behaviour of
• total revenues,
• total costs, and
• operating income
• as changes occur in the output level, selling
  price, variable costs per unit, or fixed costs.

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CVP Graph

• (000)
  245
  Revenue
  
  231
  Total expenses
• 
  
  
  
  
  
• 3,000 3,500 Units

Break-even
210
84
10
Using CVP

• Management is considering an advertising campaign
  that would cost Rs.1,00,00,000.
• Managers expects High Sales by 5000 tonnes
• Decision ??
• Should Selling Price per tonne be changed ?

11
Sensitivity Analysis

• Sensitivity analysis is a what if technique
  that examines how a result will change if the
  original predicted data are not achieved or if
  an underlying assumption changes.
• WHAT IF
• VC per unit changes ?
• SP per unit changes ?
• Sales (in units) changes ?
• FC changes ?

12
Operating Leverage

• The degree of operating leverage shows how a
  percentage change in sales volume affects income.
• Degree of operating leverage Contribution
  margin Operating income

13
DC IDC

• Direct costs of a cost object are those that are
  related to a given cost object (product,
  department, etc.) and that can be traced to it in
  an economically feasible way.
• IDC are related to the particular cost object but
  cannot be traced to it in an economically
  feasible way.
• Cost-Tracing describes the assignment of direct
  costs to the particular cost object.

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Why Cost Allocation?

• IDC are often a large of the overall costs
  assigned to such cost objects.
• WHY?
• To provide information for economic decisions
• To motivate managers and employees
• To justify costs or compute reimbursement
• To measure income and assets for reporting to
  external parties

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Criteria for CAllocation

• Cause-and-effect
• Managers identify the variable or variables that
  cause resources to be consumed.
• Benefits-received
• Managers identify the beneficiaries of the
  outputs of the cost object.

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Criteria (contd)

• Fairness or equity
• This criterion is often cited on government
  contracts when cost allocations are the basis for
  establishing a price satisfactory to the
  government and its suppliers.
• Ability to bear
• This criterion advocates allocating costs in
  proportion to the cost objects ability to bear
  them.

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CONCEPTS

• COST POOL
• Cost pool is a grouping of individual cost items.
• COST ALLOCATION BASE
• Cost Allocation Base is a factor that links in a
  systematic way an Indirect Cost or group of
  indirect costs to a Cost Object.

18
Well have a Tea Break?
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Evolution of ABC

• Harvard Business School professors Robert S.
  Kaplan and Robin Cooper propounded the concept of
  ACTIVITY BASED COSTING - ABC.
• ABC is designed to clean off the inadequacies in
  conventional cost-accounting practices, and
  provide more accurate cost information for
  strategic and management decision-making.

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Introduction

• Activities generate transactions.
• Transactions generate costs.
• ABC traces costs to activities.
• ABC attempts to trace the cost of each activity
  as closely as possible to the reason why
  resources of SMSE were consumed in support of the
  necessary activities.

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ABC

• With the help of ABC, the indirect costs which
  might otherwise be simply accumulated and
  assigned on the basis of volume in traditional
  cost accounting system, are now assigned to
  activities performed, such as setting up
  machines, receiving and handling material, and
  dispatching the finished products.

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ABC(2)

• Then the expenses of each activity are assigned
  to products or customer based on their demand for
  the activities such as the number of set-ups, the
  number of inbound material shipments, or the
  number of separate shipments to the customers.

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ABC (3)

• ABC systems refine costing systems by focusing on
  individual activities as the fundamental cost
  object.

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ABC(4)

• ABC calculates the costs of individual activities
  and assigns costs to cost objects such as
  products and services on the basis of the
  activities undertaken to produce each product or
  service.

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ABC Benefits

• 1) Accurate Product Costs
• 2) Measuring Resource Usage
• 3) Measuring Product Profitability
• 4) Measuring Customer Profitability

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Who implements ABC?

• W S Industries
• Philips
• Bharat Forge
• Emco Transformers
• Menon Menon
• And MANY MORE

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Undercosting and Overcosting

• Product undercosting
• A product consumes a relatively high level of
  resources but is reported to have a relatively
  low total cost.
• Product overcosting
• A product consumes a relatively low level of
  resources but is reported to have a relatively
  high total cost.

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PRODUCT COSTING
High
Volume
Low
Complexity
Low
High
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L for Lunch?
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Cost Hierarchies

• A cost hierarchy is a categorization of costs
  into different cost pools on the basis of the
  different types of cost drivers (cost-allocation
  bases) or different degrees of difficulty in
  determining cause-and-effect relationships.

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Hierarchy of Activities

• Unit Level Activities
• Batch Level Activities
• Product Sustaining Activities
• Customer Sustaining Activities

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Activity Cost Drivers

• Transaction Drivers
• Duration Drivers
• Intensity or Direct charging

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Implementing ABC

• Step 1 Identify the chosen cost objects.
• Step 2 Identify the direct costs of the product.
• Step 3 Select the cost-allocation bases to use
  in allocating indirect costs to the products.

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Implementing ABC

• Step 4 Identify the indirect costs associated
  with each cost-allocation base.
• Overhead costs incurred are assigned to
  activities, to the extent possible, on the basis
  of a cause-and-effect relationship.

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Implementing ABC

• Step 5 Compute the rate per unit of each cost
  allocation base used to allocate indirect costs
  to the products.
• Step 6 Compute the indirect costs allocated to
  the products.
• Step 7 Compute the costs of the products by
  adding all direct and indirect costs assigned to
  them.

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Activity-Based Management

• ABM describes management decisions that use
  activity-based costing information to satisfy
  customers and improve profits.
• Product pricing and mix decisions
• Cost reduction and process improvement decisions
• Design decisions

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ABCM Systems Are Most Beneficial When...

• significant amounts of indirect costs are
  allocated using only one or two cost pools.
• all or most costs are identified as output
  unit-level costs.
• products make diverse demands on resources
  because of differences in volume, process steps,
  batch size, or complexity.

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ABCM Systems Are Most Beneficial When...

• products that a company is well-suited to make
  and sell show small profits while products for
  which a company is less suited show large
  profits.
• complex products appear to be very profitable and
  simple products appear to be losing money.

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ABCM Systems Are Most Beneficial When...

• operations staff have significant disagreements
  with the accounting staff about the costs of
  manufacturing and marketing products and services.

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Limitations of ABCM Systems

• The main limitations of ABC are the measurements
  necessary to implement the system.
• ABC systems require management to estimate costs
  of activity pools and to identify and measure
  cost drivers for these pools.

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Limitations of ABCM Systems

• Activity-cost rates also need to be updated
  regularly.

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CUSTOMER PROFITABILITY

• Each unit of Income does not generate equal Net
  Profit
• Differences in Customer Profitability arises
  because of
• differences in revenues
• differences in costs

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DIFFERENCES IN REVENUE

• Differences in prices charged per unit to
  different customers
• Differences in the Sales Volume across different
  customers
• Differences in the Products delivered to
  difference customers

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DIFFERENCES IN COST

• Differences in the way difference customers use
  the Co.s resources.
• Differences in Distribution Channels
• Differences in Customer Services Levels

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Conclusion

• Many managers are convinced that ABC offers many
  benefits but still they are concerned about the
  perceived costs and complexity of implementation.
  Different products, brands, customers and
  distribution channels make tremendously different
  demands on SMSEs' resources.
• The gross number printed in Balance Sheet and
  Profit and Loss Account of an SMSE reflect the
  decisions made and actions taken throughout the
  business.

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Conclusion (2)

• They represent thousands of activities in form of
  small stories about how SMSE designed, produced
  and delivered its products, served customers and
  developed and maintained brands.
• ABC is more a management concept rather than a
  narrowed cost accounting tool. ABCM is a system
  to measure the performance of business.

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Thank You
Nothing is more terrible than activity without
insight. - Thomas Carlyle
Dr. Jatin Pancholi Website http//www.jatinpanch
oli.com
Dr. Jatin Pancholi has compiled and prepared this
note from various sources, as the basis for class
discussion rather than to illustrate either
effective or ineffective handling of a management
situation. The handling of a management
situation requires personal guidance by a
professional. To obtain copies, request
permission to reproduce and to send feedback,
please contact via website http//www.jatinpanchol
i.com. Those wishing to co-author next edition of
this handout are requested to contact via the
website.