traditional & abc
DESCRIPTION
TRANSCRIPT
Overheads are absorbed on volume related measures like:
Number of units producedAmount of material consumedAmount of direct labour costMachine hoursDirect labour hours
But there are many activities not related to physical volume.
Overheads have been allocated to products by using three steps:
(i)From ledger accounts to production and service departments
(ii)From service departments to production departments
(iii)From production departments to end products
Overhead Cost
Stage 1: Overheads assigned to production
departmentsProduction Departme
nts
Products
Stage 2: Overheads allocated to products
Departmental overhead allocation
rates
1) Blanket overhead recovery acceptable when valuing stocks for financial reporting but inappropriate when used for decision making and typical product strategy decisions. Such decisions have implications over 3-5 years and over this period many fixed costs become variable.
2)Traditional fixed versus variable cost split is often unrealistic since as business grows they often become more complex.
3)Decisions based on distorted cost information because of difficulties in traditional costing system in collection, classification, allocation and recovery of overheads to individual products.
4)Traditional accounting confined merely to furnishing information at product level. The new manufacturing technology demands the feedback of performance while production is still in progress rather than history.To overcome these inadequacies of overhead absorption and short term biasing of marginal costing, Activity Based Costing (ABC) has been researched
ABC is a technique under which the overhead costs of the organization are identified with each activity, which is acting as the cost driver. Examples of cost drivers are:Machine set-ups, purchase orders, quality inspections, power consumed, miles driven etc.
Activity Based Costing (ABC) is that costing in which costs are first traced to activities and then to products.
The more complex an organization’s operations , the more cost driving activities it is likely to have.
Overhead Cost
Stage 1: Overheads assigned to cost
centres / cost pools
Activity Cost pools
Activity Cost driver rates
Products
Stage 2: Overheads assigned to products using
cost driver rates
The key areas of ABC are:Product Cost differentiationActivities and their cost drivers Identification of non-value added
cost
Identify the functional areas or major activities involved in production.
Examples: machine related activities, divert labour related activities, support activities like ordering, receiving etc.
The activities may fall into four categories Unit level activities or Primary Activities Batch Level Activities Product Level Activities Facility Level Activities
Activities performed each time a unit is produced.
They are repetitive activitiesExample: Direct labour hours,
Machine hours, Power are used each time a unit is produced
Costs of unit level activities vary with the number of units produced
Activities performed each time a batch of goods or products is produced
Costs of batch level activities vary with the number of batches but are fixed with respect to the number of units in each batch
Example: Machine setups, inspections, production scheduling, materials handling
Activities performed to support the production of each different type of product
Example: Maintenance of equipment, engineering charges, testing routines, maintaining bills of materials
Activities needed to sustain a factory’s general manufacturing process
These are common to a variety of products Most difficult to link to product specific
activities Examples: Factory management,
maintenance, security, plant depreciation
A cost centre also called a cost pool be created for each activity.
Cost of resources consumed over a specified period must be assigned to each activity
These costs will have to be apportioned on some suitable basis.
Example: Total costs of all set ups might constitute one cost centre for all setup related costs.
Cost Driver is a factor that influences cost
Most suitable cost driver in each activity under functional areas should be identified
Example: In production scheduling, driver will probably be the number of batches ordered.
FUNCTIONAL AREAS
ACTIVITIES SUITABLE COST DRIVERS
Materials Management
• Issue of purchase orders
• Number of purchase orders
• Inspection of materials
• Number of purchase orders
Stores Management
• Storing of materials • Value of materials stored
• Servicing of requisitions
• Number of requisitions
• Inspection & Verification
• Number of times inspected
• Stock Taking • Value of stock
Quality Control • Testing of Samples • Number of batches produced
FUNCTIONAL AREAS
ACTIVITIES SUITABLE COST DRIVERS
Marketing • Demand Creation • Increase in sales
• Advertising • Increase in sales
• Despatches •Number of orders
Personnel Management
• Recruitment of employees
• Number of employees recruited
• Maintenance of leave records & attendance
• Number of employees
Research & Development
• Research • Number of research Projects
Machining • Setup Cost • Number of production runs
• Power cost •Machine hours
Cost of the activities is traced to products on the basis of their usage of the activity, expressed in terms of the chosen cost driver(s).
Example:
Thus a batch generating 3 purchase orders would be charged 3 x Rs. 200 = Rs. 600 for purchasing overheads.
Total Costs of purchasing Rs. 2,00,000
Number of Purchase Orders
1,000
Cost Driver rate Rs. 200
ABC is needed in organizations for product costing where:
Production overheads are high in relation to direct costs
There is a great diversity in product range
Products use different amounts of overhead resources
Consumption of overhead resources is not primarily driven by volume
TRADITIONAL ABC
1. Cost Pools One or a limited number
Many, to reflect different activities
2. Applied Rate
Volume based, financial
Activity based, non – financial
3. Suited for Labour intensive, Low overhead companies
Capital intensive, product diverse, high overhead companies
4. Benefits Simple, inexpensive Accurate product costing, possible elimination of non-value –added activities
The following are the advantages of ABC:
Helps in reducing costs by providing meaningful information for cost management which helps in making the right decision
Provides due importance to non-manufacturing cost which constitute a substantial portion of total cost
Provides reliable and accurate cost information
Enables management in formulating an effective pricing policy while fixing prices
Accuracy in indirect cost allocation to products, helpful in make or buy decisions and transfer pricing
Uses multiple cost drivers since concerned with all activities within & beyond the factory
Can be more complex than traditional since uses numerous cost pools & multiple cost drivers
Difficulties in the implementation of ABC system such as selection of cost drivers, assignment of common costs, varying cost driver rates etc.
Different levels of utility for different organizations such as beneficial for large manufacturing firms as compared to smaller firms, advantageous for firms following cost plus pricing as it gives accurate product cost.
Can prove costly to manage ABC System
Most common motives for establishing ABC System are:
To improve product costing where a belief exists that existing methods undercost some products and overcost others, or
To identify non value adding activities in the production process which might be a suitable focus for attention or elimination
Number of distinct practical stages in ABC implementation are:
Staff Training: Co-operation of work force is critical to successful implementation of ABC as they are closest to the process and most aware of the problems
Process Specification: Informal but structured interviews with key personnel will identify different stages of production process, commitment of resources to each, processing times and bottlenecks.
Activity definition: listed transactions must be rationalized in order to aggregate those in similar categories and eliminate those deemed immaterial.
Activity Driver Selection: Single driver covering all transactions grouped together in an ‘activity’ probably does not exist and multiple driver models are not desirable as seen from the cost benefit analysis
Costing: Single representative activity driver can be used to assign costs from activity pools to the cost objects.
‘Service organizations ideal candidates for ABC’ Kaplan & Cooper
Due to privatization, deregulation & increasing competition, service organizations need to accurately measure cost and resulting profitability for their services, customers and markets.
ABC can understand their cost base and make decisions on value added/ non value added activities
ABC supports Corporate Strategy in many ways:
Accurate product costing helps management compare profits from various customers, product lines, brands or regions. Takes decisions on pricing strategy, dropping unprofitable products, lines etc.
Helps in redesigning products Evaluate new process technologies
Reduce setup times Rationalization of plant lay out to reduce
material handling cost Reduction in demand for organizational
resources by comparing resource spending and resource consumption
Helps managers to focus their attention & energy on improving activities
Activity performance and efficiency can be measured – helps in budgeting
XYZ Co. has 3 clerks responsible for processing purchase invoices. Salary paid to them is Rs. 3,00,000 p.a. and invoices processed by them are 5000 per year. In addition to salary, company spends Rs. 90,000 per year for forms, postage etc. During the year 12,500 invoices were processed. Required (i) activity rate for purchase order activity and break it into fixed & variable components (ii) total activity availability and break it into activity usage & unused activity (iii) total cost of resources supplied broken into activity usage & unused activity.
(i) Activity Rate =
= Rs. 66 per invoice
Fixed Activity Rate = = Rs. 60 per invoice
Variable activity rate = = Rs. 6 per invoice
(ii) Activity availability = Activity usage + unused activity = 12,500 invoices + 2500
invoices = 15,000 invoives
3. Costs of resources supplied = Cost of activity used + cost of unused activityRs. 9,00,000 + (Rs. 6 x 12,500)= (Rs. 66 x12,500) + (Rs. 60 x 2500)Rs. 9,75,000 = Rs. 8,25,000 + 1,50,000
A company manufacturing two products furnishes the following data for a year:
Product
Annual Output (units)
Total Machine
hours
Total number of purchase
orders
Total number of
set-ups
A 5,000 20,000 160 20
B 60,000 1,20,000 384 44
The annual overheads are as under:
Volume related activity costs Rs. 5,50,000
Set up related costs Rs. 8,20,000
Purchase related costs Rs. 6,18,000
Calculate cost per unit of each Product A&B based on (a) Traditional Method of charging overheads (b) Activity based costing method
(a) Traditional method of charging overheads:
Rs.
Volume related activity costs
5,50,000
Set-up related costs 8,20,000
Purchase related costs 6,18,000
Total Costs 19,88,000
Total Machine Hours (20,000 +1,20,000) = 1,40,000
Total cost per hour (Rs. 19,88,ooo/ 1,40,000) = Rs. 14.20
Cost per unit of A = (20,000 x Rs. 14.20)/5000 = Rs. 56.80
Cost per unit of B = (1,20,000 x Rs. 14.20)/ 60,000 = Rs. 28.40
(b) Activity based costing method of charging overheads:
Volume related activity cost per machine hour: Rs. 5,50,000/ 1,40,000
= Rs. 3.9286
Set-up costs per set up: Rs. 8,20,000/ 64 = Rs. 12,812.50
Purchase related costs per purchase order: Rs. 6,18,000/ 544
= Rs. 1136.029
Cost per unit of product
Particulars Cost Driver A B
Volume related costs
Machine hours Rs. 78, 572 Rs. 4,71,432
Set-up Costs Number of set ups 2,56,250 5,63,750
Purchase related Costs
Number of Purchase Orders
1,81,765 4,36,235
Total Costs Rs. 5,16,587
14,71,417
Cost per unit Rs. 103.32 Rs. 24.52