Activity Based Costing

Better Costing for Better Decisions

Presented by :
Manoj Aggarwal
Sr. Manager Finance

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Objectives

1. Explain why indirect costs are allocated.

2. Describe the cost allocation process at a
UK Manufacturing Co.
3. Identify potential problems with cost
allocation.
4. Discuss activity-based costing (ABC) and
cost drivers at a UK Co..
5. Discuss activity-based management
(ABM) using BCG Matrix.
6. Target costing
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Indirect Costs

 Not easily and conveniently traceable to

cost objects
 Cost element is shared among cost objects
 Physically impossible to trace
 Not cost effective to trace

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Purposes of Cost Allocation

1. To provide information needed for

decision making.
2. To reduce the frivolous use of
common resources.
3. To encourage managers to evaluate
the efficiency of internally provided
services.
4. To calculate the full cost of products
for financial reporting purposes and for
determining cost-based prices.
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Purposes of Cost Allocation

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Rationale #1: To Provide Information for
Decision Making

From a decision making standpoint, the

allocated cost should measure the
opportunity cost of using a company
resource.

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Rationale #2: To Reduce Frivolous Use of
Common Resources

By not allocating costs, these resources

appear “free” to the users. But resources
never come with zero costs.

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Rationale #3: To Encourage Evaluation of
Services

The flip-side of the previous point (to

reduce frivolous usage); to compel the
current users to evaluate the costs and
benefits of the services for which they are
being charged (allocated).

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Rationale #4: To Provide “Full” Cost
Information

1. GAAP requires full-costing for external

reporting purposes.
2. In the long-run, all costs must be
covered.

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Process of Cost Allocation

Steps include:
 Identify the cost objectives

 Form cost pools

 Select an allocation base to relate

the cost pools to the cost

objectives.

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Process of Cost Allocation

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Determining the Cost Objective

Cost Objective: Determine the product,

service or department that is to receive
the allocation.

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Determining the Cost Objective

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Forming Cost Pools

Cost pool: A grouping of individual costs,

the sum of which is allocated using a
single allocation base.

Cost pools could include:

1. Departments (maintenance or
personnel departments)
2. Major Activities (equipment setups)

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Selecting an Allocation Base

1. Allocation Base: Very important to

choose a base that relates the
cost pool to the cost objectives.
2. Allocation should be based on a cause-
and-effect relationship between costs
and objectives.
3. If cause-and-effect cannot be
established, other approaches are
used.
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Other Approaches to Cost
Allocation (Fixed-Indirect)

1. Relative benefits approach.

2. Ability to bear costs.
3. Equity approach.

These are all merely accounting

convention; allocation for the sake of
allocation.

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 Activity-Based Costing

 Purpose
 Allocation of indirect costs based on causal activities
 Attempts to identify “direct” link between cost and cost
object
 Results in better allocation
 Does not provide “true” cost

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 Activity-Based Costing

 Traditional allocation method

Costs Products

 Activity-based allocation method

Costs Activities Products

First stage Second stage

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 Activity-Based Costing

 Identifies activities required to produce the

product or service
 Determines the cost of the activities
 Allocates costs to the cost object based on the
object’s consumption of activities

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The Problem of Using Only Measures of
Production Volume to Allocate Overhead

1. Traditionally firms use labor hours or machine

hours as allocation bases for assigning overhead
to products.
2. This assumes that all costs are proportional to
production volume.
3. Setup costs are not proportional.
4. For example, a setup might work for a 400,000
unit production run just as well as a 200,000
production run.
5. Low-volume items are undercosted and high-
volume items are overcosted.

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The ABC Approach

1. Identify the major activities that cause

overhead costs to be incurred.
2. Group costs of activities into cost
pools.
3. Identify measures of activities (the cost
drivers)
4. Relate costs to products using the cost
drivers.

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The ABC Approach

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Examples of Activities

1. Processing purchase orders.

2. Handling materials and parts.
3. Inspecting incoming material and parts.
4. Setting up equipment.
5. Producing goods using manufacturing
equipment.
6. Supervising assembly workers.
7. Inspecting finished goods.
8. Packing customer orders.
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Examples of Associated Costs

1. Various labor costs.

2. Depreciation.

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Examples of Cost Drivers

1. Number of purchase orders processed.

2. Number of material requisitions.
3. Number of receipts.
4. Number of setups.
5. Number of machine hours.
6. Number of assembly labor hours.
7. Number of inspections.
8. Number of boxes shipped.

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Pros and Cons of ABC

Benefits:
1. ABC is less likely than traditional costing to

undercost or overcost products.

2. ABC may lead to improvements in cost
control.

Limitations:
1. Expensive relative to traditional system!

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 When is ABC Most Useful

 High amounts of overhead cost

 Multiple products
 Complex products
 Complex production system
 Significant variation in volume between high and
low volume products

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 When is ABC Most Useful

 Different products place different demands on

resources
 Problems with current cost allocations due to
changes in products or processes
 Better cost information is needed

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“You Get What You Measure”

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 ABM: Using ABC for Performance
Management
Manage costs
 Continuous Improvement (Kaizen)
 Radical Redesign of Products or Processes (Target
costing, Business Process Re-engineering)

- Reduce the usage of the cost drivers

- Reduce the cost per unit of the driver

Set prices relative to competition and value

Eliminate unprofitable business

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Activity-Based Management (Four-Steps)

1. Determine major activities.

2. Identify resources used by each activity.
3. Evaluate the performance of the activities.
4. Identify ways to improve the effficiency
and/or effectiveness of the activities.

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Step 1: Determine major activities
through interviews and observations

a. Determine customer locations, determine

availability of stock, and prepare delivery
schedules.
b. Pick orders from warehouse.
c. Load trucks.
d. Deliver merchandise.

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Step 1: Determine major activities
through interviews and observations
(continued)

e. Return merchandise to stock if not

acceptable to customer or customer not
home.
f. Wash delivery trucks (each night).
g. Schedule truck for routine service and
nonroutine repairs.

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Step 2: Identify Resources Used By Each
Activity (ex.)

1. Return merchandise to stock (e)

a. Different item received than ordered
b. Customer not home at time of delivery
2. Wash delivery trucks (f)
a. How many trucks washed per night?
b. Salary/wage costs associated with
employees
c. Cleaning supplies, materials,
equipment depreciation

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Step 3: Evaluate The Performance Of The
Activities

1. Benchmarking.
2. Compare with other firms.
3. How do costs compare with others?

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Step 4: Identify Ways To Improve The
Efficiency And/Or Effectiveness Of The Actvities

1. Suggest improvements based on

analysis.
2. Best practices at other firms.
3. Examples:
 Have sales staff seek customer input.
 Have clerk call customers the day prior
to delivery to assure someone is home
(note: dentists office now do this
regularly).
 Consider converting part-time positions
to full-time or outsourcing washing.
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Conclusion

1. ABM focuses on process improvements.

2. ABC focuses on costing.
3. ABM often identifies “low hanging fruit,” or
costs which are out of line with
benchmarks.
4. ABM can produce substantial returns.

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Overhead Allocation Using ABC

 1ST Level Allocation

 Allocation of Expenses to Sites based upon Cost Center
Accounting
 2nd Level Allocation
 Allocation of Expenses to Respective Machines at
Respective Cost Centers
 3rd Level Allocation
 Allocation of Expenses to Respective Products based
upon Principles for Activity Based Costing

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 Statutory Warning !

Don’t Use A Sledge

Hammer to crack a Nut

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 Overhead Allocation
Overhead
Employee Cost - Production
Utilities (100%)
Employee Cost Others :-
Associated With Production
Associated With Marketing
Others - Admn
Maintenance
Rent & Rates + Insurance
1st Stage Allocation
Site Wise
Sitewise Cost Information is
available through System
Sitewise Cost Information is
available through System
Sitewise Cost Information is
available through System
Sitewise Cost Information is
available through System
Sitewise Cost Information is
available through System
2nd Stage Allocaiton 3rd Stage Allocation
Machine Wise Product Wise
Machinewise Cost Information is Direct Machine Hours worked /
available through System Product
Machinewise Cost allocation is Direct Machine Hours worked /
done on KWH and Utilization % Product
Allocated on the basis of Total
Output Tons
Allocated on Customerwise
Sales Value. Further Allocated
to Tonnage sold to that
customer
Allocated on the basis of Total
Output Tons
Machinewise Cost Information is Direct Machine Hours worked /
available through System Product
Standard Output of Machine Per Direct Machine Hours worked /
Month - On Standard Mix Product
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ABM through BCG Matrix

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BCG Matrix Existing
BCG Matrix - Existing Costing
25%

Basic
Luxury Soft 20%

Super Soft 15%

Others

10%
Ultra Soft Standard

5%
Value

0%
-200 - 200 400 600 800 1,000 1,200 1,400 1,600
-5%

-10%

Family Value -15%

-20%

-25%

-30%

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BCG Matrix After ABC
BCG Matrix - Proposed Costing
30%

Basic
Luxury Soft 20%

Others
10% Standard
Ultra Soft

0%
-200 - 200 400 600 800 1,000 1,200 1,400 Value 1,600
Super Soft
-10%
Family Value

-20%

-30%

44
 BCG Matrix After ABC Comparison
BCG Matrix - Existing Costing
25%

Basic
Luxury Soft 20%

Super Soft 15%

Others

10%
Ultra Soft Standard

5%
Value

0%
-200 - 200 400 600 800 1,000 1,200 1,400 1,600
-5%

-10%

Family Value -15%

-20%

-25%

-30%

BCG Matrix - Proposed Costing

30%

Basic
Luxury Soft 20%

Others
10% Standard
Ultra Soft

0%
-200 - 200 400 600 800 1,000 1,200 1,400 Value 1,600
Super Soft
-10%
Family Value

-20%

-30%
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BCG Matrix After Target Costing

BCG Matrix - After Taget Costing

25%

Ultra Soft Standard

20%

Family Value
Others
15% Basic

Luxury Soft
10%

Value
5%

0%
0 500 1000 1500 2000 2500 3000 3500

-5%

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