AFM Activity Based Costing ABC By Isuru Manawadu B.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 cost 400,000 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 CostsProducts/ Cost object CostsProducts First stageSecond stage

Activity-Based Costing Traditional allocation method Activity-based allocation method 8 CostsProducts/ Cost object CostsProductsActivities First stageSecond stage 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 Produc tion order pool Testing pool Parts adminis tration pool General factory pool First stage Activity pool Second stage DLH Rs./ Setup Rs./ 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 Assignment Instructions 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