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Activity Based Costing (ABC)

This document discusses activity-based costing (ABC). ABC is an accounting method that identifies activities performed in an organization and assigns the costs of each activity to products and services based on their use of the activities. It helps overcome limitations of traditional costing methods that allocate indirect costs broadly based on direct labor hours or machine hours. ABC provides more accurate product costs and helps identify opportunities to reduce costs through activity-based management.

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Parth Garg
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45 views

Activity Based Costing (ABC)

This document discusses activity-based costing (ABC). ABC is an accounting method that identifies activities performed in an organization and assigns the costs of each activity to products and services based on their use of the activities. It helps overcome limitations of traditional costing methods that allocate indirect costs broadly based on direct labor hours or machine hours. ABC provides more accurate product costs and helps identify opportunities to reduce costs through activity-based management.

Uploaded by

Parth Garg
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Activity based costing (ABC)

Why ABC?
Companies offering more than one product
E.g. Honda, Nestle.
Different products use different amount of

resources
Direct costs can be traced
Indirect costs cannot be traced
Subjected to broad averaging- simple costing

/peanut butter costing


Problem of over-costing and under-costing

Product under-costing: Product

consumes a high level of resources but is


reported to have a low cost per unit
Product over-costing: Product consumes

a low level of resources but is reported to


have a high cost per unit
Product cost cross-subsidization: If a

company under-costs one of its products,


then it will over-cost at least one of its
other products

Implementing simple costing


Identify the products
Identify the direct costs of the product
Direct material cost
Direct manufacturing labor

Select the cost allocation bases to use for allocating

indirect costs to the product


Direct manufacturing labor hours?

Identify the indirect costs for each cost allocation base


Compute the rate per unit of each cost allocation base

used to allocate indirect costs to the products


Indirect cost / direct manufacturing labor hours

Compute the indirect costs allocated to the products


Compute the total cost
Direct cost + Indirect cost

Practice problem
Plastim company manufactures two types of
lenses
Complex lens CL5, is large with multicolor

molding
Simple lens S3, single color and with few
special features
S3 S3 lens
CL5and 15000
Plastim produced 60000
CL5
in(Rs)
2012.
Direct lens
material
1125000
675000
Direct
manufacturing
Find
unit
costs oflabor
each600000
lens? 195000
(Rs)

Direct manufacturing labor


hours

30000

Total indirect cost (Rs)

2385000

9750

Additional info for practice


problem
Cost allocation
base quantity
consumption
Activity

Total Cost allocation


indire base quantity
ct
cost
(Rs.)

S3

Design

4500
00

100

Set up of
molding
machines

3000
00

2000 Set up
hours

500

1500

Molding
machine
operations

6375
00

1275 Molding
0
machine
hours

9000

3750

Shipping

8100
0

200

100

100

Distribution

3915
00

6750 Cubic feet


0
delivered

45000

22500

Parts
30
square feet

Shipments

CL5

70

In addition to existing direct costs, direct

mold cleaning and maintenance cost is also


now categorized as direct cost
S3 lens: Rs. 120000
CL5 lens: Rs. 150000

Why refine a cost system?


1. Increase in product diversity
2. Increase in indirect costs
3. Advances in IT
4. Competition in product markets

Guidelines for refining cost


system
1. Direct cost tracing
2. Indirect cost pools
3. Cost allocation bases

Activities
ABC

Assignment to
other cost
objects

Activities consume resources, and products


consume the activities
ABC system calculates the costs of individual
activities and assigns costs to products/ services on
the basis of the activities needed to produce each
product / service.

How many activities to


choose?
Too many activities
System becomes complex

Too few activities


Not rich enough to measure cost-effect

relationship between cost drivers and


various indirect costs

Implementing ABC
Identify the products
Identify the direct costs of the product
Direct material cost
Direct manufacturing labor

Select the cost allocation bases to use for allocating indirect

costs to the product


Set up hours
No. of shipments
Direct manufacturing labor hours

Identify the indirect costs for each cost allocation base


Compute the rate per unit of each cost allocation base used

to allocate indirect costs to the products


Compute the indirect costs allocated to the products
Compute the total cost
Direct cost + Indirect cost

Cost Hierarchies
Categorizes indirect costs into different cost pools on the

basis of different types of cost drivers, or cost allocation


bases, or different degrees of difficulty in determining
cause-and-effect relationships.
1. Output unit level costs: costs that vary with each unit of

product e.g. cost of energy, machine depreciation


2. Batch level costs: costs that vary with each batch of
products e.g. set-up costs
3. Product sustaining costs (or service sustaining costs): costs
of activities undertaken to support individual products or
services regardless of the number of units or batches in
which the units are produced e.g. design costs
4. Facility sustaining costs: costs of activities that cannot be
traced to individual products or services but that support
the organization as whole e.g. general administration costs

Advantages of ABC
Tracing indirect cost to products
Estimates accurate product for org with

multiple products
Useful especially when there is high
percentage on indirect cost pool
Assists managers in finding opportunities to
reduce cost
Provides information how different
overhead activities relate to the rest of the
organization
Helps the team implementing ABC to
understand the organization better

Problems of ABC
If cost driver usage is not proportional to

cost of the activity, inaccurate estimates


will occur
Difference between FC and VC is ignored
Cannot resolve problem with regard to
handling of organization level costs
Requires substantial resources to
implement ABC
ABC data can be easily misinterpreted

Comparison of ABC and ABM


ABM Resources
is used in combination with ABC to

improve processes and reduce cost


ABC
Resources

ABM

How ABC is used for activity based


management
1. Pricing and product-mix decisions
2. Cost reduction and process improvement

decisions
3. Design decisions
4. Planning and managing activities

When to implement ABC?


Significant amount of indirect costs are allocated using only one

or two cost pools


All or most indirect 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


Products that a company is well suited to make and sell show

small profits; whereas products that a company is less suited to


produce and sell show large profits
Operations staff have significant disagreements with the

accounting staff about the costs of manufacturing and


marketing products and services

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