Activity Based Costing and (ABC) Activity Based Management (ABM)

1. Activity Based Costing and (ABC) Activity Based Management (ABM) Management Level – Paper P2 Advanced Management Accounting Lecture - 01 Vidya Rajawasam ACMA CGMA MBA

2. ABC & ABM In this Lecture we will discuss • Activity Based Costing • Activity Based Management

3. ABC & ABM Activity Based Costing The calculation of full product costs by the use of financial accounting principles are not suitable for decision-making purposes. The full product costs include; direct materials, direct labour, energy costs, direct and variable overheads.

4. ABC & ABM Activity Based Costing Traditional absorption costing uses predeterminedoverhead recovery rate to charge overheads to the products. The Overheard Absorption Rate (OAR) is based on the volume of activity.

5. ABC & ABM Activity Based Costing The Decisions related to new products and special pricing decisions should be based on incremental revenues and costs/expenses approach.

6. ABC & ABM Activity Based Costing Cooper and Kaplan (1980), developed a more refined approach for assigning overheads to product costs. This new approach is known as Activity Based Costing (ABC). This approach provides useful information for decision making purposes.

7. ABC & ABM The Steps in Activity Based Costing As per Cooper and Kaplan, support activities are the main cause of many overheads. The support activities are; Materials handling, quality inspections, setting up machinery,material acquisition.

8. ABC & ABM The Activity Based Costing Philosophy • The support activities of producing products cause costs. • Products consume the related activities • The costs should be charged on the basis of consumption of activities.

9. ABC & ABM The Activity Based Costing Method • Identification of organizations major activities. • 30-50activities would be ideal • Basically identify 20% of the activities that generate the 80% of the generate of the overheads.

10. ABC & ABM The Activity Based Costing Method • Estimate the costs associated with performing each activity. • These costs are collected into cost pools.

11. ABC & ABM The Activity Based Costing Method • Identify factors that influence the cost pools. • These factors are known as cost drivers. • Example, Cost of setting up machinery will be influence by the number of setups carried out.

12. ABC & ABM The Activity Based Costing Method • Calculate the cost driver rate. • Example, rate per set up, rate per material requisition, rate per inspection. Cost Driver Rate = .Cost pool Level of cost drivers

13. ABC & ABM The Activity Based Costing Method • Charge the overheads to the products on the basis of activity usage of the products by using cost driver rates.

14. ABC & ABM Favorable conditions for ABC • When production overhead costs are high in comparison to direct costs. • When there is a greater diversity in the product range. • Where there is a greater diversity of overhead costs involved in production.

15. ABC & ABM Activity Based Cost Hierarchy Cooper & Kaplan (1991), proposed a cost hierarchy framework based on the activities that occur at four levels. • Unit level activities, these activities are performed when units are produced. The activities vary in direct proportion to the number of units produced.

16. ABC & ABM Activity Based Cost Hierarchy • Batch related activities, these activities are performed each time when a Batch is produced. The activities vary in direct proportion to the number of batches produced.

17. ABC & ABM Activity Based Cost Hierarchy • Product sustaining activities, these activities are performed to support the various products produced in the product line. The resources consumed in the production are independent from the number of units or batches produced. Example, product design costs.

18. ABC & ABM Activity Based Cost Hierarchy • Facility sustaining activities, these activities not be directly related to products lines. These activities are related to facility and building maintenance etc… Example, Plant security , business rates on premises etc…

19. ABC & ABM Review MCQs There are direct and indirect costs related to production costs of products, following are part of direct costs? • Direct materials • Direct labour • Plant maintenance costs • Quality control costs

20. ABC & ABM Review MCQs There are direct and indirect costs related to production costs of products, following are part of direct costs? • Direct materials • Direct labour • Plant maintenance costs • Quality control costs

21. Competitor Analysis Review MCQs The activity based costing product hierarchy levels are? • Facility sustaining activities • Low cost product setups • Product sustaining activities • Batch related activities

22. ABC & ABM Review MCQs The activity based costing product hierarchy levels are? • Facility sustaining activities • Low cost product setups • Product sustaining activities • Batch related activities

23. ABC & ABM ABC benefits and limitations Benefits • Provides more accurate product line costing where non volume related overheads are significant and diverse products are produced. • Provides flexibility to analyze costs by cost objects rather than processes. Cost objects are where product costs are accumulated.

24. ABC & ABM ABC benefits and limitations Benefits 3) Provides a reliable indication of long run variable product costs, which supports strategic decision making. 4) Provides financial (cost driver rates) and non-financial (cost driver volumes) measures relevant for cost management and performance management.

25. ABC & ABM ABC benefits and limitations Benefits 5) Supports identification and understanding of cost behaviour, thus supporting future cost estimation improvements. 6) Provides a more logical,acceptable and comprehensive basis for costing.

26. ABC & ABM ABC benefits and limitations Limitations 1) Little evidence to prove where ABC improves corporate profitability. 2) ABC information is internally oriented and historical, therefore lacks direct relevance for strategic decision making.

27. ABC & ABM ABC benefits and limitations Limitations 3) Practical problems related to cost driver selection. 4) The novelty of the procedure is questionable, since it involves rigorous application of conventional costing procedures.

28. ABC & ABM ABC and decision making ABC systems are designed to provide historical cost information relating to a firms’ products. ABC also helps the management in analyzing and interpreting a firms profitability.

29. ABC & ABM ABC and decision making Therefore, ABC can play a significant role in long term decision making. The involvement focuses on; • Decisions concerning product pricing strategy. • Possible changes to the product range and mix via promotion strategies. • New Product developments

30. ABC & ABM Activity Based Management (ABM) ABM is a system of management which uses ABC information for variety of purposes including cost reduction, cost modeling and customer profitability analysis. ABM is simply using information derived from ABC systems.

31. ABC & ABM Activity Based Management (ABM) ABM seeks to classify each activity in a process into value added and non-value added activities. Basically, non value added activities represent waste. Therefore, the firm should aim at eliminating them.

32. ABC & ABM Activity Based Management (ABM) Example related to Non Value adding activities; Time spent on dealing with customer complaints. This activity cannot be reduced or eliminated until the customers have nothing to complain about.

33. ABC & ABM Activity Based Management (ABM) ABM involves planning and decision making related to activities within a process and also should focus on continuous improvement of those activities. Therefore, management should recognize what activities are critical to the success of the organization.

34. ABC & ABM Activity Based Management (ABM) Once management identified the critical success factors of the organization, they must define the Costs ( cost pools/ cost drivers ) and key performance indicators for those activities. The staff must be trained and empowered to carry out these tasks.

35. ABC & ABM The outputs from the ABM system The Organizations that are involved in designing and implementing ABM will produce five basic outputs;

36. ABC & ABM The outputs from the ABM system • Understanding the cost of activities and business processes. The activates carried out by the organization forms the very core of what a businessdoes. The ABM system provides costs related to these core activities and understanding of how activities related to business processes arecarried out.

37. ABC & ABM The outputs from the ABM system • Identification of cost of non value adding activities. The identification of non value adding activities / wasteful activities is extremely useful for the management.

38. ABC & ABM The outputs from the ABM system • Actvity based performance measures Knowing only costs related to the activities performed by an organization is insufficient for the management. Therefore, they must actively focus on performance based measures such as quality, cycle time, productivity , customer service and other KPIs.

39. ABC & ABM The outputs from the ABM system • Accurate product /service costs Products/ services are provided to customers and markets through various contractual relationships or distribution channels. The products/services consume the resources at different levels and therefore, the accurate estimation of product/service costs become important.

40. ABC & ABM The outputs from the ABM system • Cost Drivers The final output of the ABM system is the cost driver information. This information is helpful in understanding business activities and managing them.

41. Competitor Analysis Review MCQs What is true related to ABC benefits ? • Provides accurate product costing • Easy to calculate the cost drivers • Provide reliable information related to long run variable costs. • Provides logical, acceptable and comprehensive costing framework.

42. Competitor Analysis Review MCQs What is true related to ABC benefits ? • Provides accurate product costing • Easy to calculate the cost drivers • Provide reliable information related to long run variable costs. • Provides logical, acceptable and comprehensive costing framework.

43. Competitor Analysis Review MCQs What is true related to ABC and long term decision making? • Supports decisions concerning product pricing strategy. • Supports decision making related to new product developments. • Supports product mix and product range calculations for sales promotions. • Non of the above

44. Competitor Analysis Review MCQs What is true related to ABC and long term decision making? • Supports decisions concerning product pricing strategy. • Supports decision making related to new product developments. • Supports product mix and product range calculations for sales promotions. • Non of the above

45. Competitive Advantage Lecture Summary We have discussed the • Activity Based Costing • Activity Based Management

46. Activity Based Costing and Activity Based Management Management Level – Paper P2 Advanced Management Accounting Lecture - 01 Vidya Rajawasam ACMA CGMA MBA