afm 31130 1 activity based costing abc by isuru manawadu b.sc in accounting sp. (usjp), aca

AFM 31130AFM 31130

1

Activity Based Costing

ABC

By

Isuru ManawaduB.Sc in Accounting Sp. (USJP), ACA

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

2

Indirect Costs

• 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

Traditional Allocation Method

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

4

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.

Criticisms of Traditional Overhead Allocation

• 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.

5

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

6

Activity-Based Costing

• Traditional allocation method

• Activity-based allocation method

7

Costs Products/Cost object

Costs Products

First stage Second stage

Activity-Based Costing

• Traditional allocation method

• Activity-based allocation method

8

Costs Products/Cost object

Costs ProductsActivities

First stage Second stage

Production or Service Department

Production or Service Department

Activity cost centre

Overview of ABC

• 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

Basic Steps required to implement an ABC system• Identify major activities

• Assigning cost to cost pools/ cetres for each activities

• Determining cost driver for each major activity

• Assigning the cost of activities to product

10

Hierarchy of Activities

Unit level Performed each time a unit is produced

Eg. Power to run processing equipment.

Batch level

Performed each time a batch is produced.

Eg. Processing purchase order

Product level

Relate to specific products and typically must be carried put regardless of how many batches or units of the product are manufactured.

Eg. Maintaining inventories of parts for a product 11

Hierarchy of Activities Cont….

Facility Level Activities

Activities that are carried out regardless of which products are produced, how many batches are run, or how many units are made.

Eg. Factory management salaries, insurance, property tax etc.

12

13

Various manufacturing overhead costs

Labour related

pool

Setup pool

Production

order pool

Testing pool

Parts administration pool

General factory

pool

First stage

Activity pool

Second stage DLH Rs./

SetupRs./

Order Rs./Test Rs. / part type

Rs./ Machine

Hours

Unit level

Batch level

Product level

Facility level

Operation of an ABC System• 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

14

Operation of an ABC System

• 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

15

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

16

When is ABC Most Useful? Cont.

• Different products place different demands on resources

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

• Better cost information is needed

17

Limitations of ABC

• Detail ABC systems are costly

• Difficult to understand

• ABC is more complex than traditional costing system

18

Activity-Based Management

• 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?

“Using ABC systems to improve financial management is called activity based management. (ABM)”

19

ABM for Process Improvement

• Focus on problems, opportunities

• Prioritize opportunities for improvement– Most critical

– Greatest potential for cost savings

20

ABM for Process Improvement

• Determine and explain causes for problems and opportunities– Cannot improve the system without first

understanding it

• Select specific improvement projects

21

Group AssignmentInstructions• Each group should have 15 students• 10 marks will be awarded

– Report 5 marks– Presentation 5 marks

• Inform the group names, registration numbers of students before mid examination

22

Group Assignment Cont….

Guidelines• Gather information about existing Strategic

management accounting concepts• Suggestions to develop a business plan• Evidence of group participation

23

Group Assignment Cont….

Topic of the group assignment – How does Strategic Management Accounting

impacts to develop a business plan.

24