ACTIVITY BASED COSTING

1. Module 11 ACTIVITY BASED COSTING Dr. Varadraj Bapat

2. Activity Based Costing (ABC) • Concept of ABC • Traditional Costing V/s ABC • Treatment of cost under ABC • Steps of ABC • Benefits • Limitations • Activity Based Management: ABM • Relation between ABC & ABM Dr. Varadraj Bapat

3. Reasons to choose the right way of costing In business, arriving at the correct cost is very important, because it: • identifies money-makers and money losers; • finds an economic break-even point; Dr. Varadraj Bapat

4. Dr. Varadraj Bapat • facilitates opportunities for cost control. • permits comparison of different options; and • enables strategic decision making.

5. The Concept of ABC Activity-Based Costing Departmental Overhead Rates Level of Complexity Plant-wide Overhead Rate Overhead Absorption Dr. Varadraj Bapat

6. The Concept of ABC Overhead Absorption Departmental Overhead Rates Department D1 OH Rate = Overheads Apportioned / Machine Hours Plant OH Rate = Overhead Cost / Machine Hours Plant-wide Overhead Rate Dr. Varadraj Bapat

7. Introduction • ABC is a costing system, which focuses on activities performed to produce products. • ABC relates cost (resources consumed) to work accomplished (outputs produced). Dr. Varadraj Bapat

8. Dr. Varadraj Bapat • ABC is a management tool that provides better allocation of resources. • The ABC or unit cost goal is a benchmark that represents an expectation of the cost incurred for the production of an output.

9. ABC aligns costs to outputs thereby increasing cost visibility, and is useful in forecasting financial baselines. Dr. Varadraj Bapat

10. Traditional Costing V/s ABC ABC Traditional Everything in Organization Resources Resources Traced by Resource Drivers Allocate Consume What is actually being done Activities Cost Centre Consume Traced by Activity Drivers - Products - Services -Products/Services - Customers - Etc Objects Objects

11. ABC’s Basic Premise • Cost objects consume activities. • Activities consume resources. • This consumption of resources is what drives costs. • Understanding this relationship is critical to successful budget management. Dr. Varadraj Bapat

12. Treatment of Costs under ABC In ABC, products are assigned the overhead costs that are supposed to be related to the allocation base. • Non-manufacturing costs • Manufacturing costs • Plant wide Overhead Rate • Departmental Overhead Rates • Costs of idle capacity Dr. Varadraj Bapat

13. ABC’s Basic Steps 1 . Analyze activities. 2 . Gather cost data. 3 . Trace costs to activities. 4 . Establish output measures. 5 . Analyze costs. Dr. Varadraj Bapat

14. ABC’s Basic Benefits • Makes it possible to determine production cost traced to outputs. • Targets areas needing management attention. • Encourages the consideration of alternative methods of production. • Highlights operational efficiency. Dr. Varadraj Bapat

15. Dr. Varadraj Bapat • Identifies financial benchmarks for activity performance. • Generates more information to measure and reward performance, and prioritizes activities for cost reductions. • Provides a common managerial framework among support activities.

16. Limitations of ABC • Trade-off between expense and accuracy. • Need for more precise data • Need of full support of top level management, and support of ABC based performance review. Dr. Varadraj Bapat

17. Cases of overstated costs and under-stated margins and mistakes in pricing and other critical decisions. Dr. Varadraj Bapat

18. Activity Based Management 18 Activity based management involves any use of ABC information to support the organization’s strategy, improve operations, or manage activities and their resulting costs. Dr. Varadraj Bapat

19. 19 Activity Based Costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs. Dr. Varadraj Bapat

20. Relation ABC and ABM Cost Assignment View Resource costs 20 Process View Activity Analysis Activity Evaluation Performance Measures Root Causes Activity Triggers Activities Cost Objects ABM Dr. Varadraj Bapat

21. Eliminating non-value added costs using ABM 21 • Identifying Activities • Identifying non-value added activities • Understanding activity linkage, root causes and triggers • Establishing performance measures • Reporting non value added costs Dr. Varadraj Bapat

22. ABM seeks to satisfy following customers needs 22 • Lower costs • Higher quality • Faster response time • Greater innovation Dr. Varadraj Bapat

23. Customer Profitability Analysis 23 Dr. Varadraj Bapat Customer profitability analysisuses activity-based costing to determine the activities, costs and, profit associated with serving particular customers.

24. Customer Profitability Analysis 24 Orders small quantities Often changes orders Requires special packaging Orders frequently • Demands faster service Dr. Varadraj Bapat A costly customer is one: