Activity Based Costing the part of Cost Accounting

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In Activity Based Accounting system the accounting technique allows a firm to determine the actual cost associated with each output and the services produced by the firm without regard to the structure of the organization. It identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs. It provides the most accurate way of assigning cost and supporting the resources business processes, services and customers. In this way, an organization can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced.

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.

Activity Based Systems first accumulate overhead costs for each of the activities of an organization, then assigning the costs of activities to the products, services, or other cost objects that caused that activity. To establish a cause-effect relationship between an activity and a cost object, cost drivers are identified for each activity. Activity Based Costing defines the kind of business done by the organization.

While using the ABC system, the activities which generate cost must be determined and then should be matched to the level drivers used to assign costs to the products. The implementation of the ABC system has the following steps:

Identifying the activities such as engineering, machining, inspection…etc.

Determining the activity costs

Determining the cost drivers such as machining hours, number of setups, engineering hours…,etc.

Collecting the activity data

Computing the product cost

Advantages of Activity Based Costing:  Traditional costing methods divide costs into product costs and period costs.  The period costs include selling, general, and administrative items and are charged against income in the period incurred.  Product costs are the familiar direct materials, direct labor, and factory overhead; these costs are traced and allocated to production under both job and process costing techniques.  However, some managers reject this methodology as conceptually flawed.  For example, it can be argued that the cost of a finished product should include not only the cost of direct materials, but also a portion of the administrative cost necessary to buy the raw materials (e.g., many companies have a separate administrative unit in charge of all purchasing activity, like writing specifications, obtaining bids, issuing purchase orders, and so forth).  Conversely, the cost of a plant security guard is part of factory overhead, but some managers fail to see a correlation between that activity and a finished product; after all, the guard will be needed no matter how many units are produced. This requires abandoning the traditional division between product and period costs, instead seeking to find a more direct linkage between activities, costs, and products.  This means that products will be charged with the costs of manufacturing and nonmanufacturing activities.  It also means that some manufacturing costs will not be attached to products.  This is quite a departure from traditional thought.

Another benefit of ABC is that a product is only charged with the cost of capacity utilized.  Idle capacity is isolated and not charged to a product or service.  Under traditional approaches, some idle capacity may be incorporated into the overhead allocation rates, thereby potentially distorting the cost of specific output.  This may limit the ability of managers to truly understand and identify the best business decisions about product pricing and targeted production levels. 

Limitations of Activity Based Costing :  One limitation of ABC is that external reporting must be based on traditional absorption costing methods.  Absorption costing requires the traditional division between product costs and period costs, with inventory absorbing all of the manufacturing costs and none of the period costs.  As a result, ABC may produce results that differ from those required under generally accepted accounting principles (GAAP).  Therefore, ABC is usually viewed as supplemental in nature.  It is used for internal management decision making, but it may not be suitable for public reporting (note: when the aggregate financial statement results do not differ materially between ABC and other methods, ABC can be used for both internal and external purposes).

The fact that ABC is not GAAP usually means that a company that wishes to benefit from ABC must develop two costing systems -- one for external reporting and one for internal management.  Some companies feel they have enough to do without working through two costing methods!  Another disadvantage of ABC is that it is usually more involved than other approaches.  Rather than applying all factories overhead on some simple basis such as labor hours, it requires the development of numerous cost pools that must be individually allocated.  In other words, ABC is a more intensive technique, and the costs to implement it may not be worth the trouble.

The Reality of Activity Based Costing:  Despite the limitations of ABC, many companies utilize the method.  A quick internet search will reveal millions of references to the approach, including various management consultant groups praising its merits.  As you might suspect, many important business decisions about the fate of a product are based on assessment of profitability, and profitability boils down to comparing sales price to cost.  Because the sales price is pretty well set, the "decision" about how to determine a product's cost is obviously quite significant in assessing the bottom-line profitability for an individual product or service.

Now, for a single-product company with fairly stable inventory levels, this is much to do about nothing.  Traditional and ABC methods will get to about the same end point.  But, for multi-product/service firms, the arbitrary allocation of costs can pretty much "make or break" the perceived profitability of each product or service.  As companies have grown larger and more diverse in output, there has been an accompanying concern about how costing occurs.  Arguably, product diversification has been a major contributing factor into the management accountant's pursuit of alternative costing devices like ABC.

Another driver of ABC-type approaches has been the advent of computer technology.  Before modern information systems, it was very expensive to manipulate data.  Most firms were perfectly content to live with simple approaches that allocated factory overhead on a single basis.  The ease with which data can be managed under a sophisticated information system greatly reduces the cost and error rate associated with ABC.  It is not surprising that the method's popularity is inversely related to data processing costs.

Example:

The following information provides details of the costs, volume and transaction cost drivers for a period in respect of XYZ Ltd:

 

Products

 

A

B

C

Sales and production (units)

90,000

30,000

15,000

Raw materials usage (units)

10

7

14

Direct materials cost ($)

30

40

15

Direct labor hours

2.5

3

1.5

Machine hours

5

3

7.5

Direct labor cost ($)

20

30

10

Number of production runs

5

10

50

Number of deliveries

18

7

50

Number of receipts

50

70

700

Number of production orders

45

25

60

Overhead costs

$

Set up

75,000

Machines

1,000,000

Receiving

900,000

Packing

650,000

Engineering

750,000

Total

3,375,000

You are required to

(a) calculate the total costs for each product if all overhead costs are absorbed on a labor hour basis;

(b) calculate the total costs for each product, using activity based costing;

Solution:

Traditional Method Direct Labor Hour Basis

The direct labor hour rate is $10, calculated by dividing the total overheads by the total number of direct labour hours:

total overheads

total number of direct labor hours

 

3,375,000

337,500

 

$10 per dlh

(Here, dlh refers to direct labor hours.)

Since we are using the direct labor hour rate method for the absorption of all overheads, the product costs per unit must be:

 

A

B

C

Direct Materials

30

40

15

Direct Labor

20

30

10

Overheads

30

15

15

Total Product Cost

25

30

40

The overheads recovered are, of course:

Direct labor hour rate x number of direct labor hours per product

For product A, for example, the calculation is:

$10 per dlh x 2.5 dlh = $25 Here, dlh refers to direct labor hours.

ABC Method (Activity Based Accounting)

As we said above, to apply the ABC method, we need to identify cost drivers for two stages:

1 cost drivers tracing the costs of inputs into cost pools; and

2 cost drivers tracing the cost pools into product costs

The workings that follow illustrate clearly how such cost drivers work through the ABC system in these two stages: an initial overhead rate or amount being further subdivided according the needs of the situation.

Workings:

The calculations for each of the rates to be used are:

The machine hour rate is the only rate that is what we might call a traditional rate. All of the other rates we are about to use involve a two stage process. We will see the elements of these two stages as we get to them.

Machine hour overhead rate

$1,000,000

= $1.5326

652,500 machine hours

 

This rate is used as normal.

For the set up costs, we first devise a rate to tell us the cost per set up: total set up overheads divided by the number of set ups: in this case, this is

$75,000

= $1,153.85

65 production runs

 

We will return to this rate shortly.

All of the other rates are calculated similarly. Hence they will be presented now without further comment.

Receiving rate

$900,000

= $1,097.56

 

820 receipts

 

Packing rate

$650,000

= $8,666.67

 

75 deliveries

 

Engineering rate

$750,000

= $5,769.23

 

130 production orders

 

All of this information can now be put together into a cost per unit statement as follows.

The final stage in the whole ABC procedure, as far as product cost determination is concerned is to find out the costs per unit. The cost per unit statement follows, and then we will work through the calculations.

Unit costs

A

B

C

 

$

$

$

Direct materials

30.0000

40.0000

15.000

Direct labor

20.000

30.000

10.000

Machine overheads

7.6628

4.5977

11.4943

Set up costs

0.0641

0.3846

3.8462

Receiving costs

0.6098

2.5610

51.2195

Packing costs

1.7333

2.0222

28.8889

Engineering costs

2.8846

4.8077

23.0769

Total Costs

$62.9546

$84.3732

$143.5257

Workings:

Machine overheads are found by multiplying the machine hour rate by the number of machine hours per product per unit:

Machine hour rate $1.5326 x

machine hours

5

3

7.5

gives

$7.6628

4.5977

11.4943

The set up costs rate we have already is the rate per machine set up, the cost per unit is calculated by multiplying the rate per set up by the number of set up per product and then dividing the results by the total number of units per product:

Set up cost per set up $1153.85 x

No of set ups

5

10

50

gives

$0.0010

0.0059

0.0592

Set up cost per set up $1,153.85 x

No of set ups

5

10

50

gives

$5,769.25

11,538.50

57,692.50

These values are then divided by the number of units per product to give us the cost per unit:

 

$0.0641

0.3846

3.8462

So, as per the above example it can be taken into the conclusion that Activity Based costing method scores over the traditional methods as it gives a more realistic absorption of indirect cost as it uses the activity as base which is major contributor to the costs concerned unlike the traditional cost which uses a single base which may or may not have any relation with the costs incurred for a particular activity. Traditional method assumes that all costs incurred in proportion to the machine hour or labor hour which tends to give misappropriate allocation of cost. In traditional method, it might happen that a particular Product does not consume a particular activity, but it costs might get appropriated over it. In ABC it will not happen. Thus, ABC is better approach as it gives proper allocation of costs which in result leads to better decision making by the management.

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