2. Product Costs Direct labor and direct
materials are easy to
Direct labor trace to products.
Direct materials The problem comes
with factory
Factory Overhead overhead.
Period Costs
Administrative expense
Sales expense
3. Typically used one rate to allocate overhead to
products.
This rate was often based on direct labor
hours.
This made sense, as direct labor was a major
cost driver in early manufacturing plants.
4. Manufacturing processes and the products
they produce are now more complex.
This results in over-costing or under-costing.
Complex products are not allocated an adequate
amount of overhead costs.
Simple products get too much.
5. Then multiple allocation bases should
be used to allocate overhead expense.
In such situations, managers need to
consider using activity based costing
(ABC).
6. Activity based costing is an approach for
allocating overhead costs.
An activity is an event that incurs costs.
A cost driver is any factor or activity that has a
direct cause and effect relationship with the
resources consumed.
7. Machine hours
Direct labor hours
Number of setups
Number of products
Number of purchase orders
Number of employees
Number of square feet
8. Assume that a company makes widgets
Management decides to install an ABC system
Overhead Cost Drivers are Determined:
Management decides that all overhead costs only
have three cost drivers.
Direct labor hours
Machine hours
Number of purchase orders
12. Lets assume the company makes two products, Widget A and Widget B:
Let’s also assume that each product uses the following quantity
of overhead cost drivers:
Base Widget A Widget B Total
Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 50 50 100
The ABC rates are:
`4,500/1,000 = `4.50 per direct labor hour
`2,500/250 = `10 per machine hour
`4,250/100 = `42.50 per purchase order
13. Widget A Base ` Rate ` Allocated
Direct labor hours 400 4.50 1,800.00
Machine hours 100 10.00 1,000.00
Purchase orders 50 42.50 2,125.00
Total 4,925.00
Widget B Base ` Rate ` Allocated
Direct labor hours 600 4.50 2,700.00
Machine hours 150 10.00 1,500.00
Purchase orders 50 42.50 2,125.00
Total 6,325.00
The original overhead to be applied was 4,500 of direct labor driven overhead + 2,500 of
machine hour driven overhead + 4,250 of purchase order driven overhead =` 11,250.
The actual overhead allocated was 4,925 for Widget A + 6,325 for Widget B = ` 11,250
14. General Ledger Amt. in `
Payroll taxes 1,000 This the total
overhead we were
Machine 500
given, the total
maintenance
Purchasing Dept. 4,000 amount is `11,250
labor as explained on
Fringe benefits 2,000
the previous slide.
Purchasing Dept. 250
Supplies
Total direct labor
Equipment 750 hours are 1,000, also
depreciation given earlier.
Electricity 1,250
Unemployment 1,500
insurance
Base Widget A Widget B Total
Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 40 60 100
15. T r t w d be:
he ae oul
OHR t =
ae Ov hea DirectLa Hour
er d/ bor s
`11,2501,0 0= `11.25 perhour
/ 0 .
A ying ov hea using t r t
ppl er d his ae:
WidgetA 4 0hour x `11.25 =
: 0 s `4 0
,50
W idgetB: 60 hour x `11.25 = `6,750
0 s
T a ov hea a ied = `11,250
ot l er d ppl
16. W A
idget W B
idget Ta
ot l
Ta iona M hod
r dit l et `4 0
,50 `6,750 `11,250
A iv yBa Cost
ct it sed ing `4,925 `6,325 `11,250
Difference - 25
`4 `425 --
0
Which is more accurate?
ABC Costing!
Note these are total costs. To get per-unit costs we would divide by the
number of units produced.
17. • Product lines differ in volume and manufacturing
complexity.
• Product lines are numerous and diverse, and they
require different degrees of support services.
• Overhead costs constitute a significant portion of
total costs.
• The manufacturing process or number of products
has changed significantly—for example, from labor
intensive to capital intensive automation.
18. Step 1 – Plan the system
What are the goals?
Inventoryvaluation
Process improvement
Foster
active involvement
Assemble cross-functional team
Functional specialists
18
19. Step 2 – Define, analyze activities and
resources
Decompose organization into elemental activities
Who does what, and why?
Interview
employees
Determine resources
Determine inputs and outputs
Gather statistics on activities
Inputs and outputs
Transaction, duration, intensity
For possible use as second-stage cost drivers
19
20. Step 3 – Establish activity cost pools
and determine first stage allocation
Firststage allocations assign costs to
cost pools
Requires costs to be re-categorized according
to why they are incurred, not by type
Drivers may be employee time, square
footage, etc.
20
21. Extendsthe use of ABC from product costing to a
comprehensive management tool that focuses on
reducing costs and improving processes and
decision making.
Decisions In ABM
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions
22. ABC gives management insight into the cost
structures for making and selling diverse
products.
It provides more accurate product cost
information and more detailed information
on costs of activities and the drivers of those
costs.
23. Manufacturing and distribution personnel use
ABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation
base.
24. Management can identify and evaluate new
designs to improve performance by evaluating
how product and process designs affect
activities and costs.
Companies can work with their customers to
evaluate the costs and prices of alternative
designs.
25. ABM classifies all activities as value-added or
non-value-added.
Value-added activities increase the worth of a
product or service to the customer.
Example: Addition of a sun roof to an automobile.
Non-value added activities don’t.
Example: The cost of moving or storing the product prior
to sale.
26. EVOLUTION OF ACTIVITY BASED COSTING IN THE
CONTEXT OF A PRODUCT LIFE CYCLE
Case summarizes the history of ABC according to the
phases of its life cycle, highlights its expanding
functionality over time, and details the lessons
learned from two decades of use.
It concludes with a description of the current state of
ABC as a key input and value adder to performance
management systems.
27.
28. Increased Japanese competition experienced by
western companies, particularly those in the
electronics and automotive verticals.
Resulted into low-wage labor & undervaluation of
currencies.
Some western companies retreated and complained
of unfair competition, and others adopted the
management practices used at leading Japanese
companies such as Toyota.
A few western companies developed innovative
practices of their own, including innovative costing
29. Tektronix, for example, allocated manufacturing
overhead to products based on direct labor, which
encouraged engineers to design products that
required less labor to manufacture.
It increased the cost of purchasing, receiving, and
stocking thousands of different parts, thereby
reducing profitability and ultimately Tektronix’s
competitiveness.
Only when the cost of procurement was allocated to
products based on the basis of activities, bias
corrected and engineers encouraged to use common
parts wherever possible.
30. Most of the large consulting firms built ABC practices in the late
80s and early 90s, and the first commercially available
software for ABC was introduced in 1990.
Underlying this enthusiasm was the recognition that ABC could
yield important insights into profitability.
This was because ABC:
Eliminated the product cross subsidies inherent in cost
accounting
Revealed the sources of loss that were responsible for the
decline in profitability
And acted as a catalyst for decisions affecting profitability.
31. Systems helped management see the profitability of products and eliminate time on
non profitable products.
32. ABC was also the victim of shifting attention to new
management methods.
Some argued that ABC was inconsistent with the principles of
continuous improvement and total quality management.
They wrote that ABC lacked customer focus, was not process
oriented, did not enhance organizational learning, and was top
down in approach (i.e., did not involve employees).
A common argument was that ABC could not reliably measure
the short-term impact of decisions on operating cost, inventory.
33. For instance, in the case where ABC revealed that
80% of a company’s products were unprofitable,
management denial precluded meaningful change.
One company’s ABC model was so complex it was
costly to maintain and difficult to understand.
Interest in ABC declined after 1992 when attention
turned to business process reengineering, enterprise
resource planning (ERP) systems and the balanced
scorecard.
The good news is that ABC crossed the chasm of
failure and continued its learning and development.
34. With continued development, however, it was clear
that ABC was applicable to areas outside the scope of
cost accounting.
These areas included administration, sales,
marketing, research and development, supply chain,
and logistics.
ABC implementations expanded into insurance,
healthcare, packaged goods, energy, banking and
other industries.
35. Government agencies and the military used
ABC to help ameliorate budget pressures.
Another development involved creating detailed
models of business processes.
The process models revealed opportunities for
cost reduction, helped prioritize opportunities
based on cost, time and quality, and allowed
tracking of the impact of improvements on
resource capacity.
36. A survey by Business Finance in 2004
indicated that 37% of companies with annual
revenues in excess of $1 billion had
established ABC programs.
ERP systems effectively integrated transactions
but were unable to guide management which
products and services to sell, and which
customers to serve.
ABC corrected these omissions and revealed
opportunities to improve financial performance.
37. New uses of ABC were developed such as
Shared services pricing models for IT.
Other corporate functions to support service
level agreements (SLAs) with business units.
Target costing for product design.
Optimization of logistics.
Supply chain and IT investments.
Minimization of the total cost of ownership of
equipment and other assets.
38.
39.
40. ABC evolved greatly over more than two
decades.
Understanding the cost-effectiveness of today’s
ABC is important to assessing its value as a
strategic tool in today’s hyper competitive and
volatile global economy.
