Activity Based Costing: Strategic Cost Management

STRATEGIC COST MANAGEMENT
Activity Based Costing
M B A THIRD SEMESTER
Dr. Mustafa K
Visiting Faculty
School of Management Studies,
DCMS, University of Calicut
[email protected]
Requirement of Cost Systems
• Valuation of inventory and measurement of the
cost of goods sold for financial reporting.
• Estimation of the costs of activities,

products, services, and customers.
• Providing economic feedback to managers

and operators about process efficiency.
Today’s businesses are working in an increasingly
complex environment.
Use of Advanced Technology
Product Life Cycle
Product Complexity
Channels of Distribution
Quality Requirements
Product Diversity
Costing Products...
Direct materials and direct labor

costs are easy to trace
Overhead cannot be traced
easily and must be assigned with
estimates
Conventional Costing
• Total Cost = Material + Labour+ Overheads
• Overheads are allocated to the products on volume
based measures e.g. labour hours, machine hours,
units produced
Will this not distort the costing in the new

environment?
Conventional Costing
Methods...
A single or plant wide rate called a predetermined

overhead rate is used:
Job Order = Direct Labor Costs
Process Cost = Machine Hours
Need for a New System
 Amount of direct labor used in
many industries has decreased
overhead from depreciation
 Total
on equipment, utilities, repairs,
maintenance has increased
Activity-Based Costing (ABC)
An overhead cost allocation system that

allocates overhead to multiple activity cost
pools and assigns the activity cost pools to
products or services by means of cost drivers
that represent the activities used.
Conventional Costing AB Costing
Economic
Element
Expenses Resources
Work
Activities
Performed
Cost Objects
Product or
Cost Objects
service
Basics of A B C
• Cost of a product is the sum of the costs of
all activities required to manufacture and
deliver the product.
• Products do not consume costs directly
• Money is spent on activities
• Activities are consumed by
product/services
Basics of A B C (contd.)
• ABC assigns Costs to Products by tracing
expenses to “activities”. Each Product is charged
based on the extent to which it used an activity
• The primary objective of ABC is to assign costs

that reflect/mirror the physical dynamics of the
business
Basics of A B C (contd.)
• Provides ways of assigning the costs of indirect
support resources to activities, business processes,
customers, products.
• It recognises that many organisational resources
are required not for physical production of units of
product but to provide a broad array of support
activities.
Activity
Any event, action, transaction, or
work sequence that causes a
cost to be incurred in producing
a product or providing a service.
Unit-Level Activities
Activities performed for each

unit of production.
Batch-Level Activities
Activities performed for each

batch of products.
Product-Level Activities
Activities performed for and

identifiable with an entire
product line.
Facility-Level Activities
Activities required to support or

sustain an entire production
process and not dependent on
number of products, batches,
or units produced.
Activity Cost Pool
The overhead cost allocated to

a distinct type of activity or
related activities.
Illustration 4-2
Activities and Related Cost Drivers

Reasoning for ABC
Cost Driver
Any factor or activity that has a
direct cause-effect relationship
with the resources consumed.
In ABC cost drivers are used to
assign activity cost pools to
products or services.
ABC systems addresses the
following Questions:
What activities are being performed by the
organisational resources?
How much does it cost to perform activities?
Why does the oranisation need to perform those
activities?
How much of each activity is required for the
organisation’s products, services, and customers?
Activity-Based Costing (ABC)
Calculate unit cost

Identify activities
Identify cost driver
Compute overhead rate
Assign overhead costs
Identify Activities
In developing an ABC system, the organisation identifies the activities
being performed:
Activity Dictionary
• Move material • Respond to customers
• Schedule • Improve products

production • Introduce new products
• Purchase material • Explore new markets
• Inspect items
Map resource costs to activities
Financial accounting categorises expenses by

spending code; salaries, fringe benefits,
utilities, travel, communication, computing,
depreciation etc.
• ABC collects expenses from this financial
system and drive them to the activities
performed.
Mapping
ABC Records
Activities Salaries DepreciationElectricity Supplies Travel Total
Accounting Records
Salaries 313,000 Business Development 20,000 25000 5000 5000 55,000
Depreciation 155,000 Maintianing Present Business 80,000 60000 50000 5000 10000 205,000
Electricity 132,000 Purhcasing Material 125,000 50000 20000 20000 60000 275,000
Supplies 25,000 Set up Machines 25,000 10000 2000 37,000
Running Machines 50,000 10000 50000 110,000

Travel 100,000
Resolve Quality Problems 13,000 5000 25000 43,000
Total 725,000
Total 313,000 155000 132000 25000 100000 725,000
Activities: Types
• Unit level: Performed each time a unit is
produced
• Batch level: Performed each time a batch is
produced
• Product level: Performed to support production
of different type of product
• Customer Level: Performed to support servicing
customers
• Facility level:Residuary head
Define activity drivers
The linkage between activities and cost objects,
such as products, customers,, is accomplished by
using activity drivers.
An activity driver is a quantitative measure of the
output of an activity.
The selection of an activity driver reflects a
subjective trade-off between accuracy and cost of
measurement.
Building an ABC Model
Identify Identify Identify
Resources Activities Cost Objects
Define Define
Activity Resource
Drivers Drivers
Enter Enter Enter

Calculate
Resource Resource Activity
Costs
Costs Driver Qty. Driver Qty.
Limitations of Activity-Based Costing
 Can be expensive to use.
 Some arbitrary allocations
continue.
Switch to ABC when...
Products differ greatly in volume and
manufacturing complexity
Products lines are
 numerous
 diverse
 require differing degrees of support services
Overhead costs constitute a significant

portion of total costs
The manufacturing process or number of
products has changed significantly
Production or marketing managers are
ignoring data provided existing system
Activity-Based Management
An extension of ABC from a

product costing system to a
management function that
focuses on reducing costs and
improving processes and
decision making.
Value-Added Activities
An activity that increases the worth of a product or service such
as...
engineering design
machine set-ups
machining
assembling
painting
packaging
Nonvalue-Added Activity
An activity that adds cost to, or increases the time
spent on, a product/service without increasing its
market value such as:
Repair of machines
Storage of inventory
Moving of materials
Building maintenance
Inspections
Inventory Control
Just-In-Time Processing (JIT)
A processing system dedicated
to having the right amount of
materials, products, or parts
arrive as they are needed,
thereby reducing the amount of
inventory.
Illustration 4-18

Requires
◦Dependable suppliers
◦A multiskilled work force
◦A total quality control system
Reduced inventory
Enhanced product quality
Reduced rework and storage
costs
Savings from improved flow of
goods

Activity Based Costing: Strategic Cost Management

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STRATEGIC COST MANAGEMENT

Activity Based Costing

• Estimation of the costs of activities,

• Providing economic feedback to managers

Use of Advanced Technology

Product Life Cycle

Direct materials and direct labor

Will this not distort the costing in the new

A single or plant wide rate called a predetermined

An overhead cost allocation system that

• The primary objective of ABC is to assign costs

Activities performed for each

Activities performed for each

Activities performed for and

Activities required to support or

The overhead cost allocated to

Activities and Related Cost Drivers

Calculate unit cost

• Move material • Respond to customers

• Schedule • Improve products

Financial accounting categorises expenses by

Supplies 25,000 Set up Machines 25,000 10000 2000 37,000

Running Machines 50,000 10000 50000 110,000

Enter Enter Enter

Overhead costs constitute a significant

An extension of ABC from a

Just-In-Time Processing (JIT)

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