1

Better Costing for Better Decisions

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��Not easily and conveniently traceable to cost objects

� Cost element is shared among cost objects

� Physically impossible to trace

� Not cost effective to trace

2

Indirect Costs

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��Need for allocation

� Estimate product or activity cost

� What does it really cost?

� Increase awareness of indirect costs

� Activities are not free

� Plan more cost efficient operations

� Now that we know what it costs, what should we do?

3

Indirect Costs

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�� Typical allocation methods

� Ability to bear

� Fairness or equity

� Benefits received

� Cause and effect

4

Allocation of Indirect Costs

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�� Indirect costs allocated to cost object based on the cost object’s consumption of some measure of activity, usually labor hours

5

Traditional Allocation Method

$10,000,000 total indirect cost400,000 total labor hours

= $25 per hour rate

A product consuming 6 labor hours would be charged $150 of indirect costs

Wali Memon

��Assumes all overhead is volume-related

� Factory-wide or departmental rates

� All related to single activity measure

�Departmental focus, not process focus

� Focus on costs incurred, not cause of costs

6

Criticisms of Traditional Overhead Allocation

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�� 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

7

Activity-Based Costing

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�� Traditional allocation method

�Activity-based allocation method

8

Activity-Based Costing

Costs Products

Costs ProductsActivities

First stage Second stage

Wali Memon

�� 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

9

Overview of ABC

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��Not all costs are volume-related

� Unit level

� Batch level

� Product level

� Facility level

10

Levels of Cost Incurrence

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�

�Assign costs to activity pools

� First stage allocation

� Identify the costs incurred to perform various activities

�Determine the measure of activity best related to each cost pool

� Cost drivers

11

Operation of an ABC System

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��Determine rate per unit of activity

�Assign costs to products/services based on consumption of activities

� Second stage allocation

� Indirect costs are converted to direct costs

12

Operation of an ABC System

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�� Step 1 – Plan the system

� What are the goals?

� Inventory valuation

� Process improvement

� Foster active involvement

� Assemble cross-functional team

� Functional specialists

13

Implementing ABC

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�� Step 2 – Define, analyze activities and resources

� Decompose organization into elemental activities� Who does what, and why?

� Interview employees

�Determine resources

�Determine inputs and outputs

14

Implementing ABC

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�� Gather statistics on activities

� Inputs and outputs

� Transaction, duration, intensity

� For possible use as second-stage cost drivers

15

Implementing ABC

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�

� Step 3 – Establish activity cost pools and determine first stage allocation

� First stage allocations assign costs to cost pools

� Requires costs to be re-categorized according to why they are incurred, not by type

� Drivers may be employee time, square footage, etc.

16

Implementing ABC

Wali Memon

�� Step 4 – Determine second stage drivers and assign costs to cost objects

� Outputs of activity analysis may be second stage drivers

� Distance moved, times handled, machine hours, units, etc.

� Amount assigned to the cost object is the amount of activity consumed times the rate per unit of the activity

17

Implementing ABC

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��High amounts of overhead cost

�Multiple products

�Complex products

�Complex production system

� Significant variation in volume between high and low volume products

18

When is ABC Most Useful?

Wali Memon

��Different products place different demands on resources

� Problems with current cost allocations due to changes in products or processes

� Better cost information is needed

19

When is ABC Most Useful?

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��Natural extension of ABC

� Why are activities performed?� Are they necessary?

� Are they consistent with organizational goals?

� How are they performed?� Are they performed efficiently?

� Can they be redesigned or eliminated?

20

Activity-Based Management

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�� Focus on problems, opportunities

� Prioritize opportunities for improvement

� Most critical

� Greatest potential for cost savings

21

ABM for Process Improvement

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��Determine and explain causes for problems and opportunities

� Cannot improve the system without first understanding it

� Select specific improvement projects

22

ABM for Process Improvement

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��Use ABC/ABM data to test potential impact of changes

�Make changes

� Iterate

� Process of continual improvement

23

ABM for Process Improvement

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�

� Shifts focus from managing costs to managing activities

�Aids in recognizing, measuring and controlling complexity

� Promotes understanding of why costs are incurred

� Provides better cost allocation information

24

Implications of ABC/ABM

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�

�Useful for planning future operations

� Fosters continuous improvement

� Likely to meet with substantial resistance

� Analysis of why and how activities are performed

25

Implications of ABC/ABM

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