Activity Based Costing Notes

Introduction to Management Accounting: Activity-Based Costing

Introduction

• Advances in technology, increasing competition, and product diversity have created a need for cost reduction.

• This led to the development of Activity-Based Management (ABM) philosophy.

• ABM started in the 1970s and 80s with large manufacturing corporations in the US.

• Traditional costing systems needed refinement to address these changes.

• Activity-Based Costing (ABC) involves a detailed analysis of the firm's cost structure by analyzing costs implicit in each activity.

• Pros: Detailed analysis.

• Cons: Costly and complex to implement.

Activity-Based Management (ABM) Philosophy

• ABM is an organizational management method based on the premise that products consume activities, and activities consume resources.

• The starting point of ABM is activity analysis:

  • List all activities used to complete a product/service.

  • Classify activities as value-added and non-value-added.

  • Eliminate non-value-added activities (e.g., bureaucratic tasks).

  • Continuously improve/reevaluate value-added activities.

• Organizational strategy and administration, research & development, customers, design, production, marketing, distribution, customer service, and suppliers are all components of ABM.

Costing Method: Activity-Based Costing

• Traditional costing assigns both direct and indirect costs to cost objects.

• ABC focuses primarily on indirect costs.

• It identifies activities that explain why indirect costs are incurred.

• Cost assignment flow: Total costs are divided into direct and indirect costs. Indirect costs are assigned to departments/cost centers, then to activities, and finally to the product cost, using cost drivers.

• Sometimes departments/cost centers are not directly used, and indirect costs are immediately assigned to Activities.

Terminology

• Activity: An event, task, or unit of work with a specified corporate goal.

• Task: A necessary step to perform an activity (also known as a sub-activity).

• Example: Hiring of employees (Activity) involves tasks like:

  • Placing announcements in newspapers/websites.

  • Studying applications.

  • Inviting selected candidates.

  • Interviewing candidates.

  • Correcting tests, etc.

Cost Driver

• The cause or the reason for a cost.

• A change in the level of a cost driver prompts a change in the amount of resources spent to perform an activity.

• Examples:

  • Activities like Product Design, Production Set-ups, Ordering of Materials, Inspection, Sales administration, Shipping, and Payroll activities have cost drivers like design hours/number of new products, set-up hours/number of set-ups, number of purchase orders, inspection hours/number of inspections, number of customer orders received, number of shipments and Number of employees respectively.

Implementing ABC

• Step 1: Determine indirect costs.

• Step 2: Assign indirect costs to departments or cost centers.

• Step 3: Identify the major activities performed by the departments and the costs of each activity.

• Step 4: Determine the cost driver of each major activity and estimate the quantity of each of these cost drivers.

• Step 5: Compute the cost rate per unit for each activity.

• Step 6: Calculate the unit costs of the cost object: Direct costs + Costs of activities required by the cost object.

How Many Activities/Tasks to Pick?

• Focus on the major activities (avoid overcomplicating the system).

• Remember the objectives of ABC:

  • More accurate product/service costs computations.

  • Better information for cost control.

• Focus on activities that truly drive costs.

• Once implemented, the system should be continuously improved and refined.

Implementing ABC: An Example

• Step 1: Indirect Costs of the period (in €):

  • Personnel: 500,000

  • Rent: 100,000

  • Telephone: 50,000

  • Depreciation: 50,000

  • Financial Costs: 100,000

  • Total: 800,000

• Step 2: IC assigned to Cost Centers (or Departments):

  • Production: 220,000

  • Warehouse: 110,000

  • Purchasing: 90,000

  • Accounting and Finance: 130,000

  • Commerce: 250,000

  • Total: 800,000

• Step 3: Determine activities (and costs assigned to them)

Total Costs of the Main Activities (in euros):

*   Planning of the production: 150,000
*   Launching of the production: 70,000
*   Receipt of materials: 20,000
*   Storage: 40,000
*   Logistic: 50,000
*   Selection of Suppliers: 30,000
*   Management of orders: 60,000
*   Authorization of payments: 20,000
*   Selection of customers: 70,000
*   Invoicing: 40,000
*   Preparation of catalogues: 70,000
*   Visiting customers: 120,000
*   After-sales Service: 60,000
*   Total Costs: 800,000

• Step 4 and 5: Determine cost driver + compute Cost Rate per unit

• Calculating product (or cost objects) costs:

  • Product A = DC + IC (requires 10 production orders + 10 components + 1 invoice + 3 purchase orders to be delivered)

  • Product B = DC + IC (requires 5 production orders + 7 components + 2 invoices + 3 purchase orders to be delivered)

  • Product C…

  • Product D…