abc analysis finance mba

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Activity-Based Costing and

Activity-Based Management


BackgroundRecall that Factory Overhead is applied to

production in a rational systematic manner, using some type of averaging. There are a variety of methods to accomplish this goal.

These methods often involve tradeoffs between simplicity and realism

Simple Methods Complex Methods

Unrealistic Realistic


Broad AveragingHistorically, firms produced a limited variety

of goods while their indirect costs were relatively small.

Allocating overhead costs was simple: use broad averages to allocate costs uniformly regardless of how they are actually incurredPeanut-butter Costing

The end-result: overcosting & undercosting


Over & UndercostingOvercosting – a product consumes a low level

of resources but is allocated high costs per unit

Undercosting – a product consumes a high level of resources but is allocated low costs per unit


Cross-subsidizationThe results of overcosting one product and

undercosting another.The overcosted product absorbs too much

cost, making it seem less profitable than it really is

The undercosted product is left with too little cost, making it seem more profitable than it really is


Case factsPlastim corp manufactures lenses for rear tail lights of

automobiles. Under its contract with Tata motorsProduces 2 types, a complex lens CL5 and a simple

lensS3.Compex lens has special features in contrast to the

simple lensOperates at capacity and has low marketing costs and

mini. customer servicing cost.Business environment very competitive with respect to

simple lensNew supplier, Jain Motors who offers to supply S3

Lens at Rs.53 well below Plastim’s price of Rs.63.Fortunately ,Same comp pressures do not exist for the

complex lens priced at Rs.132 per lens.


CL5 15,000 UNITS AND S3 60,000 UNITS 30,000 DIRECT manufacturing hours used to

manufacture 60,000 units of S3 and 9750 hours used to manufacture CL5


Decision Dilemma for PlastimPlastim’s mgt has various options available to it :Plastim can give up the Tata business in simple lenses if it is unprofitable .Jain motors makes only simple lenses and perhaps, therefore, uses simpler technology and processes than Plastim, which makes both simple and complex lenses .The simpler operations may give Jain motors a cost advantage that Plastim cant match.If so it is better for Plastim to not supply S3 lens to Tata.Plastim can reduce the price of simple lens and either accept a lower margin or aggressively seek to reduce cost


Simple costing system using a single Indirect cost Pool used by Plastim1.Identify the products that are chosen Cost

objects- 60,000 simple S3lenses & 15,000 complex CL52.Identify the Direct cost of the products 3.Select the cost allocation bases to use for

allocating Indirect costs to the products – Plastim uses direct Manufacturing labor hours as the only allocation bases to allocate all the manufacturing & non manufacturing indirect costs to S3 & CL5.

4.Identify the indirect costs associated with each cost allocation base

5.Compute the indirect costs allocated to the products.

6.Compute total cost of the products by adding all direct and indirect costs.


4.Identify the indirect costs associated with each cost allocation base

Compute the rate per unit of each cost-Allocation Base:Budgeted Indirect-Cost Rate = Budgeted TCs in Indirect Pool/Budgeted total quantity of cost allocation base =23,85,000/39,750=Rs 60 per direct manufacturing labour hours


An Example: Plastim


Plastim & Simple Costing


The mgt team identifies the foll 7 activities by developing a flowchart of all the steps & processes needed to design ,manufacture, distribute S3 & CL5

Design products & processes.Set up molding machines to ensures that the

molds are properly held in place and parts are properly aligned before manufacturing starts.

Operate molding machines to manufacture lensesClean & maintain the molds after lenses are

manufactured- Identified as direct cost

Prepare batches of finished lenses for shipmentDistribute lenses to customersAdminister and manage all processes at Plastim


Implementing ABC at PlastimIdentify the products that are chosen as cost objectsIdentify the direct costs of the productsSelect the activities and the cost allocation bases to

use for allocating indirect costs to the productsIdentify the indirect costs associated with each cost

allocation baseCompute the rate per unit of each cost allocation

baseCompute the indirect costs allocated to the productsCompute total costs of the products by adding all

direct and indirect costs assigned to the products.


Plastim and ABC Illustrated


Cost Hierarchies- categorises various activity cost pools on the basis of the different types of the cost drivers, or cost allocation bases ,or different degrees of difficulty in determining cause & effect relationships.

Output-unit level costs –are the costs of activities performed on each individual unit of a product or service. Eg:Machine operations cost

Batch Level costs are the cost of activities related to a group of units of products or services rather than to individual unit of product or service. Eg: Setup costs

Product Sustaining Costs are the costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced.


Eg: Design Costs, Product research & development costs, marketing costs to launch new products.

Facility Sustaining costs are the costs of activities that cannot be traced to individual products or services but that support the organization as a whole.Eg:General Administration costs(including top mgt compensation, rent and building security)


Plastim and ABC Rate Calculation


Plastim and ABC Product Costs


Plastim: Simple & ABC Compared


ConclusionsEach method is mathematically correctEach method is acceptableEach method yields a different cost figure, which

will lead to different Gross Margin calculationsOnly Overhead is involved. Total Costs for the

entire firm remain the same – they are just allocated to different cost objects within the firm

Selection of the appropriate method and drivers should be based on experience, industry practices, as well as a cost-benefit analysis of each option under consideration


A Cautionary TaleA number of critical decisions can be made

using this information;Should one product be “pushed” over another?Should one product be dropped?

Accounting for overhead costs is an imprecise science. Accordingly, best efforts should be put forward to arrive at a cost that is fair and reasonable.


Rationale for selecting a more refined costing systemIncrease in product diversityIncrease in Indirect CostsAdvances in information technologyCompetition in foreign markets


Cost HierarchiesABC uses a four-level cost structure to

determine how far down the production cycle costs should be pushed:Unit-level (output-level)Batch-levelProduct-sustaining-levelFacility-sustaining-level


ABC vs. Simple Costing SchemesABC is generally perceived to produce

superior costing figures due to the use of multiple drivers across multiple levels

ABC is only as good as the drivers selected, and their actual relationship to costs. Poorly chosen drivers will produce inaccurate costs, even with ABC


Activity-Based ManagementA method of management that used ABC as

an integral part in critical decision-making situations, including:Pricing & product-mix decisionsCost reduction & process improvement

decisionsDesign decisionsPlanning & managing activities


Signals that suggest that ABC implementation could help a firm:Significant overhead costs allocated using one

or two cost poolsMost or all overhead is considered unit-levelProducts that consume different amounts of

resourcesProducts that a firm should successfully make

and sell consistently show small profitsOperations staff disagreeing with accounting

over manufacturing and marketing costs


ABC and Service / Merchandising FirmsABC implementation is widespread in a

variety of applications outside manufacturing, including: Health CareBankingTelecommunicationsRetailingTransportation

abc analysis finance mba

Documents

supply s3 lens

allocating indirect costs

cost allocation bases

indirect costs allocated

indirect costs

cost objects

simple lens

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