abc manoj 1
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Activity Based Costing
Better Costing for Better Decisions
Presented by :
Manoj Aggarwal
Sr. Manager Finance
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Indirect Costs
Not easily and conveniently traceable tocost 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 fordecision making.
2. To reduce the frivolous use ofcommon resources.
3. To encourage managers to evaluatethe efficiency of internally providedservices.
4. To calculate the full cost of productsfor financial reporting purposes and fordetermining cost-based prices.
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Purposes of Cost Allocation
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Rationale #1: To Provide Information forDecision Making
From a decision making standpoint, the
allocated cost should measure theopportunity cost of using a company
resource.
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Rationale #2: To Reduce Frivolous Use ofCommon Resources
By not allocating costs, these resources
appear free to the users. But resourcesnever come with zero costs.
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Rationale #4: To Provide Full CostInformation
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 costobjectives.
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Process of Cost Allocation
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Determining the CostObjective
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 orpersonnel 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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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
Activity-based allocation method
Costs Products
Costs ProductsActivities
First stage Second stage
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Activity-Based Costing
Identifies activities required to produce theproduct or service
Determines the cost of the activities
Allocates costs to the cost objectbased on theobjects consumption of activities
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The Problem of Using Only Measures ofProduction 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 toproduction 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
Different products place different demands onresources
Problems with current cost allocations due tochanges in products or processes
Better cost information is needed
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You GetWhat You Measure
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ABM: Using ABC for PerformanceManagement
Manage costs Continuous Improvement (Kaizen)
Radical Redesign of Products or Processes (Targetcosting, 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 activitiesthrough 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 activitiesthrough 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 EachActivity (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 TheActivities
1. Benchmarking.
2. Compare with other firms.
3. How do costs compare with others?
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Step 4: Identify Ways To Improve TheEfficiency And/Or Effectiveness Of The Actvities
1. Suggest improvements based onanalysis.
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 thisregularly).
Consider converting part-time positionsto 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
3
rd
Level Allocation Allocation of Expenses to Respective Products basedupon Principles for Activity Based Costing
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Statutory Warning !
Dont Use A Sledge
Hammer to crack a Nut
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Overhead Allocation
Overhead 1st Stage Allocation 2nd Stage Allocaiton 3rd Stage Allocation
Site Wise Machine Wise Product Wise
Employee Cost - ProductionSitewise Cost Information is
available through System
Machinewise Cost Information is
available through System
Direct Machine Hours worked /
Product
Utilities (100%)Sitewise Cost Information is
available through System
Machinewise Cost allocation is
done on KWH and Utilization %
Direct Machine Hours worked /
Product
Employee Cost Others :-
Associated With ProductionSitewise Cost Information is
available through System
Allocated on the basis of Total
Output Tons
Associated With Marketing
Allocated on Customerwise
Sales Value. Further Allocated
to Tonnage sold to that
Others - AdmnAllocated on the basis of Total
Output Tons
MaintenanceSitewise Cost Information is
available through System
Machinewise Cost Information is
available through System
Direct Machine Hours worked /
Product
Rent & Rates + InsuranceSitewise Cost Information is
available through System
Standard Output of Machine Per
Month - On Standard Mix
Direct Machine Hours worked /
Product
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ABM through BCG Matrix
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BCG Matrix Existing
Val
t
rs
Sta
ar
Basi
Ultra Soft
L
x
ry Soft
Family Val
S
r Soft
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10 %
15 %
20 %
25 %
-200 - 200 400 600 800 1,000 1,200 1,400 1,600
BCG r x - x s Cos
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BCG Matrix After ABC
Value
Others
Standard
Basic
Ultra Soft
Luxury Soft
Family Value
Super Soft
-30%
-20%
-10%
0%
10 %
20 %
30 %
-200 - 200 400 600 800 1,000 1,200 1,400 1,600
BCG Matrix - Proposed Costing
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BCG Matrix After ABC Comparison
Value
Ot
e
Standard
Basic
Ultra S
t
uxury S
t
Family Value
Super S
t
-
-
-
-
-
400 6 00 800 1 ,000 1 ,
00 1,400 1 ,600
BC M ix opos d Cos in
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BCa
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Exisc
inf
Cosc
inf
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BCG Matrix After Target Costing
Value
Others
Standard
Basic
Ultra Soft
Luxury Soft
Family Value
-5%
0%
5%
10 %
15 %
20 %
25 %
0 500 1000 1500 2000 2500 3000 3500
BCG Matrix - After Taget Costing
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